If you ever read Bloomberg, WSJ, or put on Bloomberg TV or CNN Finance (big fan of
here), you've probably heard about the dreaded Inverted Yield Curve. It's supposed to be this super-scary finance thing that shows
So what is it, and why does it really show?
What is a Yield Curve?
The yield curve compares the returns ("
yields") on bonds by the same issuer over different maturity periods. 99% of the time, people talk about the
yield curve of the United States Treasury (UST) notes, because banks and governments use UST as the safe haven and universal store of value.
UST yields typically move depending on investors' confidence. When the economy is doing well, investors take money out of USTs and into riskier, more profitable assets. Prices of USTs go down, or their yields go up. Conversely, when the economy is shaky, investors are cautious and would rather keep money in risk-free USTs, driving prices up and yields down.
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| (Normal) Yield Curve, per May 2018 |
The normal shape of the yield curve is positive, an increasing (hyperbolic) curve. This implies that for the same issuer (e.g. US government), investors still demand a premium to put money in long-term (e.g. 10-year vs 2-year) bonds.
Curse of the Inverted Yield Curve
That's in
normal economic
times. A few times in the past 50-years, the yield curve
gets
inverted, i.e. the spread between US10Y vs US2Y goes to zero or even
negative. This means, investors want to put money in long-term
risk-free notes, because
they're pessimistic on near-term investment opportunities and would rather not lose principal. Conventional wisdom says this is a
robust sign of a recession
-- typically a severe one. For instance, spreads went negative during
the 1979 energy crisis, 1990s Iraq war, 2000 dotcom bubble crash, and
2007 global financial crisis.
 |
| Negative spreads in the past 50 years |
On the flip side, there are some contrarians, like
John Mauldin,
who argue that inverted yield curve suggest investor overreactions, and
that it either (i) is an indicator that's way too early, or (ii)
presents opportunities for substantial gain.
What are other signs of recession?
Some other leading indicators are the
VIX index (the "fear" index: it's actually just a futures contract for global market volatility). Some countries also publish PMI (producers manufacturing index) and CCI (consumer confidence index), which are widely accepted leading indicators for the strength of their economies. There are some unconventional measures as well, such as the
skyscraper index (e.g. if a region builds
way too many skyscrapers e.g. Dubai, then it's bound to hit a recession).
So does that mean the world will end in 2019?
Yes, duh! Did you read anything I've wrote this far?
As you can see in the chart above, spreads hit negative in December. But even looking at the 50-year trend, cyclical recessions tend to happen every 8-10 years, and the last one hit in December 2007. Since then, the Dow Jones Industrial Average has soared from 6,600 up to 25,000+ in 2018.
So recession is probably way past due.
Perhaps it has something to do with, I don't know,
US$14tn of quantitative easing (QE) by the Fed, ECB, and BoJ, and Zero Interest Rate Policy (ZIRP),
flooding the world with liquidity? Not to mention the 2018 Trump tax cuts, basically adding a
US$2.3tn sugar high to an already overheated economy -- leaving behind some
US$22tn of US public debt and a central bank with
no good tool respond to slowdowns. So the question is whether irrational exuberance can continue to overcome gravity, or if what goes up must eventually come down.
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| Dow Jones Industrial Average, 2008-19 |
In any case, as wise-ass
John Maynard Keynes once said,
the market can stay irrational longer than you can stay solvent. If I could accurately predict the markets, I would make so much $$$ so I could be chillin' on a beach in Tora Bora with Gal Gadot, instead of sitting here blogging for my two followers (six if you include Russian bots).
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| Quantitative Easing, 2008-18 |
Further reading
Enjoy! (No, I haven't read the below)
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