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Inverted Yield Curve is a “Curve Ball” that Fools Experts

by Frederick P. Baerenz, AIF®
 
Remember just a few months ago, many experts were prognosticating a weakening US and Worldwide economic environment?  They frequently cited the inversion of the yield curves for 2 year and 10 year US debt.   Think of interest rates for Certificates of Deposit.  Usually, the longer the term of the CD, the higher the interest rate.  If you plotted those rates versus time, it would indicate a smooth upward sloping curve.  If for some reason, shorter duration CDs actually offered a higher interest rate, that curve would be “inverted”.  Over the last month many analysts are falling all over each other while racing to tout encouraging economic news.  Why were so many “experts” wrong just three months ago, and how should investors weigh similar “glass half empty” forecasts in the future?
 
First of all, what were the base indicators just three months ago?  It is true that an inverted yield curve has been one of the most accurate forecasting tools for decades in predicting recession and subsequent public stock market corrections, usually six to eighteen months before they occur.  It has literally been the “canary in the coal mine”, warning of bad news just around the corner.  The logic is pretty basic.  The Federal Reserve controls short term interest rates, while longer term rates are primarily controlled by market-based factors.  Hence, if the FED is more concerned about inflation, they will raise short term rates to tighten lending and try and slow the economy and forestall unhealthy inflation (generally more than a 3% increase in inflation on an annual basis is “unhealthy”).  On the other side, if the Federal Reserve fears that the economy is slowing, they will reduce short term interest rates in an attempt to make it easier for businesses and consumers to borrow (and hopefully spend) money to boost the economy.  In 2019, the FED, fearing a slowing economy (or fearing that they had boosted interestrates too aggressively in 2018) lowered short term rates in July, September and October.  Because long term rates did not follow quickly, this caused short term to “invert” for a few days in October.  
 
What information should these “experts” have considered to avoid being “fooled”?  
1. On Chart One below, the inversion only lasted a few days.  When the inverted yield curve has been predictive of a slowing economy and market correction in the past, the inversion was much more pronounced over a longer period of time;
2. Chart Two shows a very low rate of jobless claims and a very healthy labor force participation rate.  In previous recessions/corrections both of those measurements were moving in unhealthy directions;
3. Chart Three shows both Consumer Confidence and Small Business Confidence in very healthy territory;
So, the next time you hear “experts” forecasting doom over an Inverted Yield Curve, check these other economic measurements.  If they aren’t moving in an unhealthy direction, give the Yield Curve an opportunity to adjust.   As we learned in Little League Baseball, don’t swing at a “curve ball” in the dirt.
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