Titled “Out-of-the-box Thoughts on the Yield Curve”, Steve Saville throws out some very good commentary on the current yield curve inversion. I have to admit that his commentary has defined my own understanding of what yield curve inversion really means and what (if anything) it forecasts.

The gist goes something like this… A yield curve inversion is not an end-all-be-all of indicators. The inversion point is basically a threshold that may or may not be relevant — the maximum inversion point may be well below zero (inversion). As the yield spread contracts, it is basically in a down-trend. It can continue in that trend for a long time, regardless of somewhat arbitrary thresholds along the way. While there are real fundamental consequences for inversion — it is less expensive to borrow long term debt, and this fuels mal-investment — yield curve inversion is basically comparable to other technical situations — Dow at 12,300 or VIX at 11. Sure, those seem like extreme values, but the fact that the value is extreme does not preclude values that are even more extreme or an end to the current trend.

On a fundamental basis, having an inverted yield curve is bad. However, when it goes from inverted back to normal it will not be a sign of strength, but rather a signal that the tide has turned and that we will likely see a credit contraction for a significant amount of time.

If we take a look at a chart of the yield spread with the TYX:IRX ratio (also a 3 year view), we can see that there has been a consistent downtrend with nary a sign of changing direction. It might also be worth re-reading my liquidity analysis from October, and noting the fact that in 2000 the yield curve was inverted for 6 months before changing direction.