Sun 3 Dec 2006
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.
December 3rd, 2006 at 12:36 pm
Fascinating find! So this author seems to assume that for the near future there’s still a good amount of liquidity in the markets. There’s still more gas in the tank to fuel this rally. If the curve inverts further, that’s not necessarily a bad sign for the short term. The inversion of the curve itself isn’t good, but the environment it reflects is a boon in the short-term.
I think it’s good to keep in mind that the change in trend will be the trigger. Right now, the market seems to already have digested the concept of an inverted curve. Heartburn will set in once the curve begins to straighten back up.
We’re in a higher risk situation now, but there seems to still be great opportunities for profit. This year’s been a surprisingly good investment year on many fronts (Gold’s up roughly 25%, REITs are up roughly 30%, S&P500 is up 10%, International stocks are up on average 15% or higher, general Bond funds are even up a smidge). A quick look at many charts seem to suggest that most markets are still trending upward. There’s still an upside to this broad rally on many fronts, and the inverted yield curve does suggest that more speculative short-term money is flowing around now relative to more conservative long-term investments.
December 3rd, 2006 at 2:18 pm
The point isn’t whether or not there is still “gas in the tank” — that is a separate question… the trend could change tomorrow, or could have changed on 11/22/06. But the credit expansion didn’t stop when the yield curve first became inverted in August.
It is worth noting that the article was written in August when quite a few people (like John Mauldin) were proclaiming impending doom, so it was quite timely and just as the current rally was getting started.
I personally don’t think we’ve seen the final top, and this year has been rich across many asset classes as you point out… but only time will tell.