[Mikeyd03]

I'm just curious what the implications of an inverted yield curve are. I want to understand the macro effects. So if long term yields are higher than short term (2 vs 10 year) what's the impact. I notice our GDP is strong, unemployment low, earnings seems to be up. But I just want to understand if this is artificially propped up through keeping low interest rates. I'm invested in equities, but the past few recessions have been preceded by an inverted curve, curious your thoughts. Thanks

[Rudideviz]

An inverted yield curve refers to short-term yields being higher than long-term yields, meaning that the bond market has priced in a booming economy in the near-term (=tightening monetary policy leading to higher rates) but a weakening economy in the mid to long term (=loosening monetary policy leading to lower rates).

Short-term = 2 year treasuries
Mid to long-term = 10 year treasuries

So the meaning of an inverted yield curve is that investors are predicting rates will be lower in the mid to long term. Since lower rates signal a weaker economy it is potentially a good recession predictor.

The interest rate cycle is extremely important to understand because everything that happens in the economy is basically a function of monetary policy conditions.

Low rates (= easy monetary policy)-> it’s cheap to borrow money -> companies start investing more -> asset prices rise across the board -> confidence grows leading to more investment etc and you have a self-reinforcing positive feedback loop

Higher rates (= tight monetary policy) -> it becomes expensive to borrow money -> companies start being more discriminatory with their investments, requiring a higher IRR (internal rate of return) in order to compensate for higher debt servicing costs -> contracting money supply (since less money is being borrowed) -> asset prices start stagnating/falling -> companies get even more stingy etc. leading to a negative reinforcing feedback loop

Most of the time everything that happens in macro-economics comes down to the following fundamental equation (which basically says as much as I did):

M x V = P x T

M = money supply
V = velocity of money (assume constant)
P = macro-economical aggregate price level
T= # of transactions (assume constant)

Realize that in a fractional reserve fiat system, which is our current system, debt is money. Since interest rates directly control borrowing appetite/debt levels, they control whether the monetary supply is set to contract or expand (M down or up), which will tell you if prices are going higher or lower in the future (P up or down), which is ultimately the most relevant piece of information as an investor.

[Mikeyd03]

Thank you for the detailed, well thought out explanation. This is exactly what I was looking for. Do you believe that this could be a self fulfilling thing though? Meaning sense inverted yield curve has been an indicator of recession in the past people will sell of prematurely and move into things like gold? Thank you again.

[Rudideviz]

(07-11-2018 01:20 PM)Mikeyd03 Wrote:  

Thank you for the detailed, well thought out explanation. This is exactly what I was looking for. Do you believe that this could be a self fulfilling thing though? Meaning sense inverted yield curve has been an indicator of recession in the past people will sell of prematurely and move into things like gold? Thank you again.

Yes absolutely. Herd psychology has a big impact on the economy.

However I wouldn't be too preoccupied with trying to predict recessions unless you are planning to run a macro hedge fund.

There's an old joke that the stock market has forecasted nine out of the last five recessions. The truth is timing is really hard and there haven't been many examples of people who got it consistently right.

[DonnyGately]

2sv10s aren't even the best indicator however. For reasons that are obvious to some and not so obvious to others.

[Mikeyd03]

So would you suggest 10 vs 30, 20 vs 30? If so why? I’m very curious on this topic.