5 December 2018


Cogito Ergo Non Serviam

Yield Curve Inversion Signals Slow-Down


There is a saying on Wall Street that the dumb money is in the stock market, and the smart money is in the bond market. It is usually said by people in the bond market. Yet, there are some signals the bond market gives off that are exceedingly accurate predictors of future financial activity. Yesterday, there was a yield-curve version, when the yields on shorter-term Treasurys go higher than those of longer-term instruments. That usually precedes an economic slow-down. The question is whether this signals two consecutive quarters of economic shrinkage, the definition of a recession.

The yield curve is a line drawn to represent the interest paid on instruments of equal credit risk with different maturities. All US Treasury instruments have the same credit risk because the issuer is the same. The maturities range from T-bills that mature in months to T-notes that mature in one to 10 years and T-bonds that go out beyond 10 years.

CNBC explained, "In the more immediate case, the market is concerned that the 2-year note yielded higher than its 5-year counterpart during Tuesday trading. The general interpretation is that an inverted curve means investors are worried about longer-term growth and expect yields to be lower further out on the curve. Inverted curves have been reliable recession indicators for the past 50 years."

The two instruments to which bond market pros give greatest weight are the 3-month and 10-year. When the 3-month yield exceeds the 10-year, it is serious. That has no happened yet. Instead, they are 49 basis points apart (0.49%). This is the smallest spread in 11-years, and 11 years ago, it was 2007, right at the beginning of the Great Recession.

The economy grew at 4.2% in the second quarter of this year, and the second estimate for the third quarter is 3.5% growth. It remains a strong growth rate for a developed economy, but the trend is downward. The Congressional Budget Office expects that trend to continue into 2019.

This is only logical. The current expansion has been going on for years, and it will become the longest in US history if it goes on a few more months. The Federal Reserve is raising interest rates, which slows down economic activity. Finally, the tax cuts from last year have cycled through the economy, and so, the fiscal stimulus is over. Lower growth is not a difficult prediction to make.

The question is whether that means a recession, negative growth for two quarters. There are factors in the global economy that could bring the growth rate to below zero. The US-China trade war is one such factor, and the ham-fisted handling of the relationship in Washington is not likely to improve. The British departure from the EU is not going to come without costs for the UK, Europe and the world. The US government still have a deficit and a debt ceiling to consider, and that means there could be a government shut-down out of sheer political stupidity. This journal believes slower growth is a metaphysical certainty in 2019, but for there to be a real recession, one or more of the global factors will have to kick in mightily to really do damage.

Economics always has political ramifications, and the list of presidents who win a second term and the list of presidents who have their economic crisis early in their presidencies are almost identical. Presidents who go into election season with sluggish or negative growth lose. The Trump presidency (which exists simply because blue-collar workers in the Michigan, Wisconsin and Pennsylvania voted for him) is particularly vulnerable to economic misfortune. Mr. Trump has sold himself to his base as a successful businessman who can produce an economic miracle for everyone and who will look out for the forgotten working class. If things feel like they are getting worse next year, it may well be more lethal the Mr. Trump's re-election hopes than Robert Mueller and Nancy Pelosi combined.

© Copyright 2018 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Ubuntu Linux.

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