14 Reasons Why An Inverted Yield Curve Isn't The End Of The World


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This article appears courtesy of Institutional Investor
Source: InstitutionalInvestor.com
Dave Hoffman

The cliffhanger ending of 2005 was whether the inverted yield curve between the two and 10-year treasury bonds is reason to believe that a nasty recession lies ahead. Historically – or, to be precise 60 per cent of the time - an inversion has predicted a recession within one year. InstitutionalInvestor.com took matters into its own hands and asked analysts, economists and asset managers whether today's inverted curve really is a harbinger of impending economic doom and gloom. The varying opinions, 14 of them in all, were stark contradictions to a looming recession. Some were actually downright cheery.
               1.     Spikes in foreign investments and an increase in investments in derivatives and hedge funds are helping to stabilize the economy. "Rates are low and attractive relative to rates around the world," says Margo L. Cook, CFA, managing director and head of institutional fixed income management for BNY Asset Management, The Bank of New York. "There has been a pretty good demand for U.S. assets. Unless inflation spikes, there should be low nominal rates."
               2.     Foreign investments in trade and oil exports from Asia and the Middle East have funneled large amounts of U.S. currency into both private and public banks and government investment councils in those countries. "Essentially, foreigners coming into possession of dollars are choosing to keep those dollars in U.S. Treasury and agency securities," said Richard Brown, chief economist of the FDIC. "Those are long-term assets, and that demand tends to keep the long-term rates lower than otherwise they would be."
               3.     The yield curve inversion is right on track for the historical 18 month window for federal interest rate hikes to show an effect, says Maryann Dimaggio, director of fixed income research for Evaluation Associates. "You have a period where the Fed raised the rate 13 times," she says. "You'd think the backend of the curve would rise with the short end, but that hasn't happened because of all the backend buying."
               4.     Long end buyers didn't react to the fed raising rates because there isn't the strong fear of inflation that usually motivates federal interest rate increases, as in 1994 and 1999.
               5.     A glut in the futures market, which has 150,000 long futures contracts outstanding. This means too many long buyers in the 10-year market, and too much congestion, says Matthew Smith, portfolio manager for fixed income for Smith Affiliated Capital.
               6.     "Valuations are not as extended as they were back in the late 90s. Interest rates are lower, and we don't have the market euphoria," says Henry Chip Dickson, CFA, chief U.S. strategist and associate director of equity research for Lehman Brothers. Factors such as the internet stock bubble and the bailout of Long Term Capital Management in the late 1990s preceded the 2001 recession, and the slump of 1990 came in the wake of the previous decade's savings and loan crisis.
               7.     There are different types of yield curve inversions, depending on which maturities are being compared. Despite the overnight rates increasing, the only inversion that has occurred has been between the two and 10-year treasuries. Other short term bonds whose inversions with the 10 have been known to precede recession in the past have remained positive, and Dickson notes that the three-year has more predictive power.
               8.     In his strategy report, Dickson noted that the yield curve inversion in general has lost some of its predictive power since the 1970s because "we have a more global economy that's tied more to financials, and derivatives are more important."
               9.     Corporate balance sheets are more stable than in the 1970's.
               10. Bank funding is coming from more stable and often cheaper core deposits.
               11. A strong stock market also dilutes the inverted yield curve's correlative strength. "Normally you see stocks falling along with yield curves inverting," says Bill Schneider, managing director of DiMeo, Schneider, and Associates, LLC, who recommends investors stay with their current asset allocation. "You wouldn't see markets reaching four-and-a-half-year highs." 
               12. It's too early to look at an inversion as a harbinger of problems, says Brown. "If you get an inversion of more than 100 basis points, it is an indicator. It's pretty much flat right now," he says.
               13. There are multiple flat yield curves throughout the world, specifically in the U.K., Germany and Japan.
               14.  A flattened curve will encourage more opportunities for bonds with intermediate maturities prohibiting extreme consequences, says John Norris, senior v.p. and chief economist for Morgan Asset Management, a subsidiary of Regions Financial Corporation. "Once that happens, new money starts going to the middle of the curve, into four to seven year instruments, like the five year treasury."
Either way, we'll see for sure soon enough. Stay tuned.