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Per Arne Karlsen

Inversion of the yield curve

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Mr. Salsman,

Could you explain how and why the inversion of the yield curve causes economic recessions. Is it because the inversion forces all the participants in the market to be short range?

Thanks,

Per Arne Karlsen

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This is Richard M. Salsman's reply to the question posed by Per Arne Karlsen.

It would be more accurate to say that an inverted Treasury yield curve SIGNALS (forecasts) recessions (and bearish stock markets), not that it "causes" them per se. Interest rates reflect time preference, a technical term in economics which simply reflects the trade-off we all make between short-term and long-term goals. If a culture is dominated by a shorter-term orientation (whether due to culture norms or government policy), the result is higher interest rates; a culture dominated by a longer-term orientation, in contrast, enjoys lower interest rates. A special application of this theory studies the determinants (and implications) of variations in the difference ("spread") between long-term and short-term interest rates at points in time - i.e., the "yield curve."

For those unaware of what we're talking about, the Treasury yield curve is essentially a picture, at any point in time, of the various interest-rates paid on borrowings by the U.S. Treasury at various maturities. Interest rates are plotted along the vertical axis while maturities of short-term T-Bills (due in 3-12 months), medium-term T-Notes (due in 2-7 years) and long-term T-Bonds (due in 10 years or longer) are plotted along the horizontal axis. For a "moving picture" of the Treasury yield curve since 1977 (a series of snapshots) see "The Living Yield Curve" at http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve. For another "movie" of the changing shape of the Treasury yield curve - this time super-imposed on the performance of the S&P 500 since 1997 - see http://stockcharts.com/charts/YieldCurve.html (once you get into the site click on the button labeled "animate" and you'll eventually see an inversion of the yield curve, due mostly to Fed rate hikes, prior to the stock-price crash of 2000-2001).

Three main factors determine the shape (slope) and height of the yield curve: 1) the "term premium" demanded by investors, 2) investors' expectations about the future level of interest rates and 3) investors' expectations about inflation or deflation (i.e., a decline or rise in money's purchasing power). The "term premium" reflects the fact that the longer one lends money (buys a Treasury security) the more one is uncertain about its ultimate repayment - and thus one demands a higher interest rate on securities of longer-term maturity than for those securities of medium-term or shorter-term maturity. In addition, Arbitrage Pricing Theory (APT) plus a long history informs us that longer-term interest rates represent investors' expectations of future short-term interest rates (unfortunately, this application of APT is far too technical for a complete elaboration to the audience in this Forum). Finally, investors demand to be paid higher interest rates (across the entire maturity spectrum) to the extent they expect to be paid back, in the future, in less-valuable money (inflation); likewise, they are satisfied to accept lower interest rates (across the entire maturity spectrum) to the extent they expect to be paid back, in the future, in more-valuable money (deflation).

Under the gold standard Washington tended not to deficit-spend, so its credit risk was low, and the dollar did not exhibit inflation risk. Thus the yield curve was both low and relatively flat - its normal condition. For example, when the dollar was as good as gold short-term interest rates in the U.S. averaged less than 2%, while long-term rates averaged less than 4%.  But under fiat paper money, inflation risk has been high and volatile; thus the yield curve has been both higher and more steeply-sloped than it was under the gold standard. Since 1971 (when the U.S. government severed the dollar from any remaining link to gold), the 3-month T-Bill rate has averaged 6.00%, while the 10-year T-Bond yield has averaged 7.65%. Thus the average bond-bill yield spread (a convenient way to measure the "steepness" of the yield curve at any point in time) has been 1.65% points (7.65% bond yield minus 6.00% bill yield). In its normal (average) condition, the fiat-paper-money yield curve has been upward-sloping, with long-term rates above medium-term rates and the latter above short-term rates.

A few more points are required to fully understand the forecasting power of the yield curve: 1) unlike stocks, which may or may not pay a dividend, securities that pay a fixed interest rate (such as Treasury securities), whether these securities be bills, notes or bonds (known collectively as "fixed-income securities") pay interest regardless of the economic climate; 2) historically and on average, returns on stocks have exceeded returns on (relatively safe) bonds, while returns on bonds have exceeded returns on (relatively safer) notes and returns on notes have exceeded returns on bills (the relatively safest of all the fixed-income instruments); and 3) for all fixed-income instruments, interest rates move inversely with prices, so in a climate of rising interest rates the prices of bonds, notes and bills decline (because they carry, on their face, a relatively lower fixed interest rate compared to the now-prevailing higher interest rates - and thus are worth less, in price, than when they were first issued), while in a climate of declining interest rates the prices of bonds, notes and bills rise (because they carry, on their face, a relatively higher fixed interest rate compared to the now-prevailing lower interest rates - and so are worth more, in price, than when first issued).

When the yield curve inverts - i.e., when bill yields are above bond yields - it means investors are aggressively buying bonds (price up, yield down), which are much safer than stocks - because they expect stocks to perform badly (as they tend to do prior to and during a recession). Think of this as people aggressively buying plywood to board up their windows and protect their investment in anticipation of a pending hurricane. Bill yields trading above bond yields (an inverted yield curve) also means investors expect the future short-term interest rate to decline (i.e., they expect the Fed to cut its short-term rate, as it tends to do during and after a recession).  Finally, when bill yields trade above bond yields bills investors are being paid relatively more to keep their assets in bills - which are "near-cash" - which is almost like hoarding money in a bank account (or under the mattress); this is yet another example of investors effectively anticipating a pending financial-economic "storm" (i.e., a recession and/or a stock-price decline).

From the standpoint of time preference, think of an inverted yield curve as describing the following situation: an investor is more short-term oriented (higher interest rate) in the near future (T-Bills, due in less than a year) while at the same time he expects to be more long-term oriented (lower interest rate) in the far-distant future (T-Notes or T-Bonds, due in a number of years). This effectively characterizes an "emergency" - where one faces a near-term threat or loss (see below) but expects an eventual "return to normalcy." Investment - which is nothing other than a demand for savings - declines, which lowers longer-term interest rates, which characterizes recession. Equally, think of a steeply-sloped yield curve as describing the following case: an investor is more long-term oriented (lower interest rate) in the near future (T-Bills, due in less than a year) but at the same time expects to be more short-term oriented (higher interest rate) in the far-distant future (T-Notes or T-Bonds, due in a number of years).  Investment rises, which raises the demand for savings, which in turn raises longer-term interest rates - i.e., the normal condition of prosperity.

By the way, you should know that Federal Reserve officials are well-aware that an inverted yield curve signals recession and bearishness; the Fed's research departments have issued dozens of reports in the past decades documenting the forecasting power of the yield curve. Thus yield curve inversions, which happen precisely because the Fed purposely raises short-term rates above long-term rates, represent deliberate Fed policy.  Armed with false economic theories, Fed officials believe they must cause periodic recessions in order to "fight" inflation (which they believe is caused by "excessive" rates of economic growth and from factor "bottlenecks" accompany such growth) or else to fight "speculation" (whether they believe there's a "bubble" in stocks or houses).

Two final points are worth mentioning, for context: 1) the severity and duration of recessions and bearish stock markets usually reflect the severity and duration of prior yield-curve inversions; thus, if bill yields trade well above bond yields and do so for an extended period of time (sometimes longer than a year, such as the yield-curve inversion of 2000-2001), the results are likely to be very bearish. If instead bill yields trade only slightly above bond yields and do so for a limited time (such as the yield-curve inversion of 1989), the results are likely to be only mildly bearish; and 2) while an inverted yield curve usually signals trouble ahead for stock prices, the bearish stock result is much worse when, surrounding inversion, stocks are already richly priced, with high P/E (price-earnings) multiples - e.g., 30X in early 2000; the bearish result is less severe when, surrounding the inversion, stocks are not-so-richly priced (P/Es of 10X or less). Since 1950 the average P/E on U.S. stocks (the S&P 500) has been 15X.  Today's P/E is 18X. Since the P/E is simply the reciprocal of the "earnings yield" (E/P) on stocks, note that the higher is the P/E, the lower is the earnings yield (analogous to a bond yield) - reflecting a longer-term investment orientation; in contrast, the lower is the P/E on stocks, the higher is the yield - reflecting a shorter-term orientation. 

One bizarre aspect of popular investment "analysis" today is that most people believe a "high P/E stock market" is a reckless market, replete with "irrational exuberance" and "bubbles;" in fact, such a low-yielding market reflects a longer-range ("sober," long-term and rational) orientation.  Equally, most people believe a "low P/E stock market" is "more reasonable" - indeed, a market that's seen a "correction" of its prior "mistake;" in fact, such a high-yielding market reflects a shorter-range, less-rational orientation. I'm not saying that people are "more rational" when they assign high P/Es to stocks and less rational when they assign low P/E's; I'm making a deeper point, that prosperity goes hand-in-hand with long-range thinking and planning (i.e., "normalcy"), while stagnation and retrogression go hand-in-hand with short-range thinking and planning (i.e., "emergency").

Richard M. Salsman, CFA

President & Chief Market Strategist

InterMarket Forecasting, Inc.

1777 Fordham Boulevard - Suite 202-4

Chapel Hill, North Carolina  27514

EMAIL: RMSalsman@intermarketforecasting.com

WEB: intermarketforecasting.com

IFI is an investment research and forecasting firm that quantifies market-price indicators to guide the asset allocation decisions and trading strategies of pension plans, asset managers, financial institutions and hedge funds.

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