If you watch or read any of the financial media outlets, you’ve heard of the "Flattening/Inverted Yield Curve". Greenspan has referred to it as a “Conundrum” since long-bond yields have fallen while he repeatedly increases the overnight Federal Funds rate. This phenomenon has caused our esteemed Federal Reserve Chairman great consternation.
An "inverted yield curve" is very significant because many economists and financial professionals interpret an inverted yield curve to be a conclusive leading indicator of a future recession. While I do believe that a recession in the next 18 months is a real possibility, I do not believe the Yield Curve will serve as a leading indicator. Here's why it is different this time! (I use italics to denote sarcasm because any decent investment profession'al will tell you to always be leery when somebody tells you that “it is different this time”.)
While Greenspan calls it a "Conundrum", the flattening yield curve is simply the unintended consequence of exporting enormous amounts of wealth to Asian and Middle Easterner countries whose central banks now control our bond markets. The result is a yield curve that is out of our control and thus we must rely on the benevolence of foreign central banks. Foreign central banks have three objectives.
- First, they want to keep debt as cheap as possible so we’ll keep taking it on to buy their stuff.
- Second, they want to keep our currency as strong as possible so we can buy as much of their stuff as possible without buying our own stuff.
- Third, they have to be sure that banks are continually incentivized to loan money.
The third point is key! The yield curve will not fully invert any time soon because if it does, it is not profitable for U.S. banks to loan money. (The yield curve may remain partially inverted for some time.) It would be very bad for the global economy if US banks quit loaning money. Foreign Central Banks will gladly allow debt to become more expensive (i.e. allow long-bond rates to increase) and allow the US$ to weaken to avoid a fully inverted yield curve. It's a simple case of the lesser of two evils.
The result will be a yield curve that is flat as possible without fully inverting. While the yield curve partially inverted in December, I do not believe that it will fully invert for a while. It will revert to a flat to slightly positive curve because that is in the near-term best interest of foreign governments. (You may notice how the curve is currently inverted at 5 years but positive at 10. Given that mortgages are based on the 10-year and mortgages are fueling our trade deficit, is it any wonder why this has taken place. Foreign Central Banks will do whatever they can to make mortgages attractive to consumers while ensuring they are profitable to banks.)
Of course this is another possibility. The scary alternative is if foreign central banks make a run on our federal government by selling off all their debt (The last major run on our banking system didn’t go so well). The result would be a huge sell-off in bonds and a much steeper yield curve. This would lead to weakness in the US$ and a huge spike in inflation. While this will likely happen at some point because of our trade deficits, it’s not in the best interest of foreign governments for it to happen any time soon. Let’s hope foreign central banks unwind their positions slowly and methodically. This will be the least painful scenario for all involved.