Market Commentary - September 2018

What is an Inverted Yield Curve and why is it in the financial news lately? In short, an inverted yield curve occurs when long-term debt (10 Year Treasury) has a lower yield than short-term debt (2 Year Treasury) of the same credit quality. 

Typically, banks borrow short term and lend money out long term and the interest rate spread (difference) compensates banks for the risk assocaited with lending. When a bank generates less income on their assets (long duration loans) than their liabilities (short-term deposits), the incentive for new loans starts to dwindle and can cause a disruption in the money supply.

Add to the equation the Federal Reserve is attempting to unwind their balance sheet and tighten monetary policy after 7 years of near zero interest rates and the "conundrum" becomes more complicated. Since the low rates have directly inflated certain asset classes, the unwind is expected to be slow which won't help push up long term rates.

The slow down of interest rates on long term bonds indicates there is a concern for long term economic growth. That in itself isn't a cause for alarm but, as mentioned above, when this occurs at the same time the Federal Reserve is raising short-term rates, the gap between short term rates and long term rates continues to shrink. The closer it gets to inverting, the louder the alarm bells get.

The last seven recessions dating back to the 1960's have occurred when short-term rates have exceeded long term-rates. It is important to remember that recessions are not based off one data point and that each recession is unique in its own way but this is still something that should be monitored closely. The Federal Reserve has limited control over long term rates as because those are shaped by inflationary expectations. The Federal Resererve uses their power to influence short term/overnight lending rates. The yield curve inverts when the Federal Reserve believes inflation is headed higher but bond investors are expecting the opposite. 

What is a bit different this time is the national debt is over $20 trillion and the Fed's balance sheet sits a tad over $4.5 trillion while, at the same time, interest rates still remain low. None of these existed when the Great Recession took hold in 2008 and left the Federal Reserve with plenty of ammunition to step in and help. That is no longer a luxury and has some worried as to what will happen in the next downturn when these mechanisms won't be available. The wild card here is economic growth. Obviously we don't know what it will be in the coming quarters but an economic slow down in the face of an inverting yield curve is not a desired outcome and could wreak havoc on financial markets. While GDP growth and productivity have been improving lately, we need to see this for a few more quarters before declaring any sort of victory.