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Should we fear an inverted yield curve?

September 1, 2018 | Commentary

  • The Federal Reserve pursued a zero interest rate policy from December 2008 until December 2015 when it raised the target Fed Funds rate to a range of .25-.50%. The next 25 basis pointincrease was a year later and since then there have been five more quarter point increases. Today the target range is 1.75-2.00% and the market widely expects another increase thismonth.
  • The Fed controls the short end of the yield curve through its Fed Funds targets. On the other hand, the market largely determines the yield on longer maturities. Those rates haverisen as well, but at a far slower pace, causing the yield curve to become nearly flat. Many commentators extrapolate this trend to anticipate an inverted curve where short ratesexceed long rates. Historically, inverted yield curves in the United States have been followed by recessions and stock market losses.
  • Flat yield curves can persist for a long time before inversions occur. 1995-1999 is one such example. For five years there were many faulty predictions of the next recession and bearmarket.
  • The yield curve is not like a compass that independently points to growth or recession. The Fed controls the arrow, either lowering rates to stimulate or raising rates to slow inflationor cool an overheating economy. Market forces including massive demand for high-quality, longer duration bonds around the world may invert the curve, but that is no certain signalof recession or stock market retreat.

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