Inverted Yields And FED Rate Hikes, What Does It All Mean?

If you’ve picked up any financial news in the recent week you probably saw headlines about the yield curve inverting and this being a recession indicator. But then nothing really explaining what that is, why it happens or what is causing it. Well let’s break it down and do just that.

Yield curve inversion is the term for when long term treasury rates drop below shorter-term treasury rates. There are several points along the curve where this can happen, but the spots where it tends to mean the most is the spread between the two and ten year rates. As of this writing, the 10 year treasury rate is currently .072% below the 2 year treasury rate, meaning that you get paid less for locking your money up for 10 years than you get for locking it up for 2. It shows that something is out of step in the economy and markets and has been a fairly reliable indicator of a coming recession.

So why would anyone be willing to lock up their money in this way? Is comes down to perception and expectation of future returns relative to where we are today. When long term yields drop below short term yields, what bond buyers are saying is that they expect returns in the future to be lower than they are today, indicating a slow down in economic growth in the system. It doesn’t mean a recession is around the corner in the next few weeks, but what history shows us is that there are sufficient indicators in the system for one to show up in the near future.

You could close your eyes and throw a dart at the wall to find a reason for a potential slowdown today, but the most glaring risk to economic growth at the moment is the combination of high inflation and the FED trying to contain it. If you go back in history, of the 9 times the FED has tried to contain inflation by raising interest rates, 8 of those times have resulted in a recession. So they’ve got a great track record of success. That said a recession by itself my be a lesser of evils, because what many people are pointing to today is stagflation, where you get a recession with increasing inflation. Essentially the most case scenario for any economy.

To give the FED some credit, trying to slow down the economy with rate hikes is like trying to dock an aircraft carrier in the dark. Its an enormous machine and there’s no way to predict what’s going to pop up once you start the process. At a certain point you’re just going to lose some paint.