Inversion countdown

[brewer12345]

The yield curve is now about 7.5 BP away from inverting (2 - 10 year treasury spread). Looks an awful lot we are going to invert, especially if the Fed keeps raising rates.

Get ready for a recession. :P

[mikew]

I am confused is inversion causing a recession based on an economic reason or is it that it has happened every time before (like the October crash)?

Mike

[Michael]

Banks stop lending money to businesses, especially small businesses, when the yield curve inverts. They refuse to loan out money for less interest than they pay on deposits. That is the situation when the yield curve inverts, since deposits are short term, and business loans are long term.

[ESRBob]

I'm confused...
Wouldn't all that frustrated demand for borrowing work, at last, to raise longer term interest rates and thus pop the curve back into concavity? I know these things can stay inverted for awhile, but if business itself isn't sick (yet) isn't it likely to be temporary? Maybe its one of those high-stakes games of chicken the Fed plays?

[Michael]

Only if interest rates were set solely by the free market.* They are not.* Also, businesses won't borrow money at a higher interest rate than they think they can earn on the money in the current environment, risk adjusted.* Many marginal projects will be initiated at very low rates, while only the most promising will be attempted at high rates.

Inversion has always been temporary in the past.* The fed is required to maximize economic growth, so they drop short rates if the economy stalls.* Businesses also know this, so they just wait rather than locking in high rates.

The fed inverts from time to time because double digit inflation stunts economic growth.* They see it as a balancing act.

[brewer12345]

Inversion doesn't necessarily cause anything to happen (except a lot of pain for financial institutions that got caught riding the carry trade). It is more of a signal. If you (correctly) think we are going to hit a recession next year, one of the smartest things you can do is buy long term (10 year) treasuries. Why? Because what is likely to happen is that the fed will realize the economy is stalling out and start cutting short term rates. This tends to drag the long end of the curve back down, and boosts long term bond prices.


Oh, and by the way, most banks don't borrow short and lend long. If they are appropriately managing their business (not all do), they are matching the duration of their borrowings with their loans so that they are hedged against interest rate changes. Mostly, this means that they borrow pretty short, like 3 month LIBOR or 6 month CDs, and they lend prettty short, like 3 month LIBOR loans, prme rate loans, and the like.

[thefed]

in the above context, what's your definition of "recession"??

[brewer12345]

Um, a decline in economic output is the usual definition.

[Dry Socks]

I thought it was when your neighbor loses his/her job

[brewer12345]

Its funny. There is an official definition of hwat a recession is, and then there is when the Fed actually reacts. In recent history, the Fed has reacted pretty aggressively and early simply because it is a lot easier to turn the ship before it really gets going in the other direction. Nobody knows what will happen with a new Fed chairman. I have the queasy feeling that Bernanke will crank rates up a couple of times just to show he isn't an inflation dove.

[wabmester]

Originally Posted by brewer12345

Inversion doesn't necessarily cause anything to happen (except a lot of pain for financial institutions that got caught riding the carry trade).* It is more of a signal.* If you (correctly) think we are going to hit a recession next year, one of the smartest things you can do is buy long term (10 year) treasuries.* Why?* Because what is likely to happen is that the fed will realize the economy is stalling out and start cutting short term rates.* This tends to drag the long end of the curve back down, and boosts long term bond prices.

Yeah, the popular theory is that investors see a recession ahead, so they buy the 10-year and that causes long rates to drop. But that's not the kind of inversion we're seeing this time. The 10-year hasn't moved for a long time. It's just the short-end being jacked up by the fed that's causing the curve to flatten. So, in this case, if we do see the economy slow down, it will be due to intentional monetary contraction.

The historically low short-term rates we had earlier caused a misallocation of capital of historical proportions. It will be interesting (and probably painful) to see how that misallocation corrects itself.

[brewer12345]

Originally Posted by wab

Yeah, the popular theory is that investors see a recession ahead, so they buy the 10-year and that causes long rates to drop.* *But that's not the kind of inversion we're seeing this time.* *The 10-year hasn't moved for a long time.* *It's just the short-end being jacked up by the fed that's causing the curve to flatten.* * So, in this case, if we do see the economy slow down, it will be due to intentional monetary contraction.

The historically low short-term rates we had earlier caused a misallocation of capital of historical proportions.* *It will be interesting (and probably painful) to see how that misallocation corrects itself.

Yeah, sure: "this time its different". Most expensive 4 words in the language, Wab.

I think there are two ways for recession to hit us. 1) the Fed overshoots on rate increases and pushes us into the ditch. 2) the USD collapses and everything imported becomes drastically more expensive, triggering inflation, a spike in long term rates and and economic slowdown. Choose your poison...

[SteveR]

Originally Posted by brewer12345

Yeah, sure: "this time its different".* Most expensive 4 words in the language, Wab.

I think there are two ways for recession to hit us.* 1) the Fed overshoots on rate increases and pushes us into the ditch.* 2) the USD collapses and everything imported becomes drastically more expensive, triggering inflation, a spike in long term rates and and economic slowdown.* Choose your poison...

Brewer,

If imported stuff got more expensive, would that drive more US production and/or sales of US produced items? If so, then would this then drive up the economy, create more jobs and more tax dollars and higher stock prices while lowering the price of US made goods and then eventually slow inflation?

[wabmester]

Originally Posted by brewer12345

Yeah, sure: "this time its different".* Most expensive 4 words in the language, Wab.

I'm not saying that anything is different this time. Just that sometimes an inverted yield curve is an indicator of investor setiment, and sometimes it's a side effect of fed policy. This time, the fed is clearly responsible for both the boom and the bust.

BTW, you might consider increasing international exposure if you're worried about the US. Right now, the UK has an inverted yield curve, but just about everybody else looks poised for growth.

[laurence]

Originally Posted by brewer12345

Yeah, sure: "this time its different". Most expensive 4 words in the language, Wab.

I think there are two ways for recession to hit us. 1) the Fed overshoots on rate increases and pushes us into the ditch. 2) the USD collapses and everything imported becomes drastically more expensive, triggering inflation, a spike in long term rates and and economic slowdown. Choose your poison...

As a wage slave for a mega corp that tracks it's colas to inflation, with a fat mortgage locked in at a low interest rate, I'm going to have to choose number 2 there.

[brewer12345]

Originally Posted by SteveR

Brewer,

If imported stuff got more expensive, would that drive more US production and/or sales of US produced items?* If so, then would this then drive up the economy, create more jobs and more tax dollars and higher stock prices while lowering the price of US made goods and then eventually slow inflation?* *

Yup, that would probably be the long term effect. However, in the short term, it would be real painful. How does $100 oil sound? How about 30 year fixed mortgage rates at 9%? All that borowing the US treasury does? Double the price in a hurry. Not a lot of fun.

With an eye towards hedging exactly that sort of scenario (plus normal portfolio diversification), I own EFA and GIM. I think commodities and real assets would also do well.

[SteveR]

Originally Posted by brewer12345

How about 30 year fixed mortgage rates at 9%?*

I used to have one a 12% back in the '80s. That was also when the bottom fell out of the Texas RE market and I bought at the top and sold at the bottom. :P I had to get a personal loan to pay the difference between sales price and the morgage. That was ugly and it took me years to make up the equity loss and payback the loan while renting and saving for a new house in a different part of the country.

I guess gold might be a good hedge.

[REWahoo]

Originally Posted by SteveR

I used to have one a 12% back in the '80s.

My 1983 mortgage was 13% and I was thrilled to get it because rates had just come down from 15%+. Not one of my better memories. :P

Of course that was also when my dad was getting 17% interest on his 3 year CD's.

[Nords]

Originally Posted by REWahoo!

Of course that was also when my dad was getting 17% interest on his 3 year CD's.

I was getting 10% on a checking account.

I thought the yield curve was staying flat because mortgage firms were holding their rates low to attract business. You know, the "we lose a little on each transaction but we have a 25% market share" philosophy. That usually corrects itself pretty quickly and it'll be interesting to see how fast the long end starts moving up now that home sales are slowing.

The worst nightmare of every third-world industrial manufacturer would be a collapsing dollar.