Tuesday, 26 March 2019 21:09

Yield curve inversion, Next what? Featured

Written by Sreeni Meka
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Recent inversion of the US yield curve spooked many and got a lot of media attention. When long-term interest rates fall below short-term rates (3 month) it is known as yield inversion. Financial institutions borrow at the short end of the yield curve and lend based on10 year bond yield. During the inverted yield curve times financial institutions have less incentive to lend funds. However, short term interest rates in the Euro region are below zero, financial institutions in the US can easily borrow funds from Europe and continue the lending process.

In this highly integrated world yield curve inversion in the US has relatively less impact due to steep yield curve at other major global economies.

The Spread between 2 year and 10-year government bonds in Germany is 54.3 basis points, in the UK it is 34.4 basis points, in Italy it is 200 basis points, 55 basis points in Russia, 77.7 basis points in India and 44.5 basis points in China. It is a clear sign that the global economy is still humming.



Yield inversion means not the end of the economic expansion, but a clear warning sign the US is heading for contraction in a year or so. After a decade of the expansion, it is natural to assume the economy may take a breather for a few months in the future. How soon? Probably not in the very near term.

The unemployment rate is historically low, consumption is at the highest level, and wage growth is higher than average due to the shortage of labor. Lower corporate taxes and private capital investments are still fueling the growth.

However prolonged government shutdown, the pace of interest rate raised by Fed in 2018, and tariff war with China have slowed the pace of the growth. Change in the Feds outlook on interest rates and bipartisan support for infrastructure spending are a couple of positive signs to support the future slow-paced economic expansion.


Yield curve inversion is the harbinger of the recession?

Not necessarily. There are many other economic indicators along with yield curve predict the future of the economy including the unemployment insurance claims, weekly hours in the manufacturing, manufacturing new orders, private house building permits, and consumer confidence.

There is no significant change in the new housing permits; recent weekly unemployment claims were at 221,000 that is 9,000 below the estimate. Average weekly manufacturing is stable, and consumer confidence is slightly negative in March.

Conference Board leading economic indicators combines multiple forward-looking indicators including the yield curve and reports the aggregate index. Historically, leading economic index starts dropping ahead of the recession gives a clear warning on how the future economy is going to be. As per the recent Conference Board report, LEI continued to expand despite the government shutdown and nasty snow storms. Leading economic indicators are pointing high at most of the global economies including China, Europe, Brazil, Australia, and India.

The exception to the rule is both UK and Japan. Understandably, uncertainty over Brexit making the capital outflow from the UK. US-China trade war, political uncertainty in Europe due to Brexit affecting export-oriented Japanese economy.

Overall, the global economy is moving forward at a nice pace at China, India, and Brazil and slower pace in Europe and healthier pace in the US.  2019 is the third year of the Presidential term. Historically the third year of the presidential term is always good for the market. (https://www.linkedin.com/pulse/18-percent-solution-sreeni-meka/). Looking at the big picture like infrastructure spending and possible US-China trade concessions, the markets in 2019 may leap forward despite the fears of the yield curve inversion. In the meantime stay invested in the market.






Building Permits: https://www.census.gov/construction/nrc/pdf/newresconst.pdf

Unemployment claims: https://www.dol.gov/ui/data.pdf

Average weekly hours of manufacturing: https://fred.stlouisfed.org/series/AWHMAN

Consumer Confidence: https://www.conference-board.org/data/consumerconfidence.cfm

Leading Indicators: https://www.conference-board.org/pdf_free/press/US%20LEI%20-%20press%20release%20MARCH%202019.pdf

Yield Curves: http://www.worldgovernmentbonds.com/


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