Published: Fri, December 07, 2018
Economy | By

The "yield curve" is inverting (gasp!) - should investors freak out?


A hint at rate cuts coming down the pipeline would offer much needed breathing room for emerging market (EM) currencies and move funds from US government bonds to other havens of interest returns causing them to appreciate against the dollar. U.S. light crude was last up 30 cents at $53.25. Usually it just keeps raising rates, yield curve be damned, and it may be about to make the same mistake, Karl writes.

In what could set the stage for a volatile 2019 if the Fed acts more aggressively than investors expect, top policymakers are maintaining their view that nosediving bond spreads don't give the same sour signal about the economy that they used to.

Economist Will Denyer of Gavekal Research notes that the yield curve has flattened, and eventually inverted, before every USA recession since the mid-1950s (see chart below).

When yields for short-term Treasurys rise above yields for long-term ones, market watchers call it an "inverted yield curve", and Wall Street starts getting more nervous. Powell in remarks last week reiterated his upbeat outlook of an economy growing above potential, with the unemployment rate the lowest in almost 50 years, and in no need of emergency level interest rates. This may, in turn, lead to lay-offs and a slowdown in employment and growth and ultimately force the Fed to cut rates to spur the economy.

The dollar has been under pressure since Federal Reserve Chairman Jerome Powell said last Wednesday that US interest rates were nearing neutral levels, which markets interpreted as signalling a slowdown in the pace of rate hikes. And when is that fuel needed?

When did the yield curve invert?

The yields on five-year Treasury notes fell below those on three-year notes on Monday - that hasn't occurred since 2007.

No - and that's why this latest flip in yields may not augur recession.

Investors are increasingly concerned, however, by a flattening of the spread between two- and 10-year Treasurys, a more fundamental benchmark of market health. But that hasn't happened yet, noted Charlie Ripley, senior investment strategist for Allianz Investment Management. It has spread to the eurozone, where the German 2-10 yield curve is at its flattest since mid-2017 at 85.70 basis points.

So should I brace for a recession?

"In the initial phase of the inversion of the yield curve markets are anxious and react more aggressively to weak data than to strong data", said Masafumi Yamamoto, chief currency strategist at Mizuho Securities. The Fed may try to reassure markets that the economy is doing well and that it is not anxious by continuing with their planned rate hike of a 25 basis points or they may single a delay of the hike.

"Investors are coming around to our downbeat view of the prospects for the USA economy", analysts at Capital Economics wrote on Tuesday, arguing that there was no reason to regard this pending yield curve inversion as different from others. Asked about the possibility of an inversion at a June press conference, Powell said "what we really care about is what's the appropriate stance of policy".

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