And now, the Inverted Yield Curve in America!
This reversal would anticipate an imminent recession in America if history is any indication.
Curves have always had a kind of hypnotic power over our senses. We are naturally equipped for this if we believe the neurophysiologist Alain Berthoz:
“Architects are criminals ... they only know the right angle. They have forgotten the pleasure of movement, of the marvelous gesture of the hand that caresses an old staircase banister ... the delicate curves and sensual curves of a beautiful building ... Now new data from psychology and neurophysiology show that our perception is a simulated action and that the brain experiences pleasure in evoking natural movements.”
Our penchant for the practice of curves will surprise neither economists (Phillips curve), nor politicians (poll curves), nor statisticians (bell curve). And if conspiracy theory enthusiasts don't like it, even the planet Earth has decided to opt for the rounded shape rather than the right angle.
In truth, there is something ineffable in the curve that cannot be found anywhere else, and mathematicians have never succeeded in fitting the round into a square: the famous squaring of the circle is impossible.
But for some time now, the curve has taken a wrong turn, its expressive power having been diverted to create fear, sometimes for a good cause. The best-known example is perhaps that of global warming, with these curves illustrating the rise in temperature observed over the last few decades, or millennia, or according to different carbon emission scenarios.
Another fresh example is the COVID-19 crisis. Our future was then conditioned to the evolution of the contaminated curve, with the famous exponential growth so much feared.
In finance, there is a malevolent curve feared by everyone
In the world of finance, economists and investors fear one curve in particular: the inverted yield curve. The reason they fear it so much is that it never announces anything good.
There is no need to invoke a curse or a voodoo doll. It is not a marabou curve, but a situation where investors anticipate a monetary policy so restrictive that it would be followed by an economic collapse: the recession. The scary word is out!
The yield curve is said to be inverted when long-term interest rates are at levels below the short-term level, as today for example, with American 10-year rates at 3.82% while 2-year rates are at 4.2%: the rate differential is then negative by almost -0.4%. Whereas usually, the opposite is true, i.e. 10-year rates are higher than 2-year rates: the rate differential is positive on average by nearly +1% over the long term.
And for good reason: investors do not like uncertainty, and uncertainty increases with the investment horizon. Thus, the investor will generally demand a premium for agreeing to hold asset A longer than asset B. The investor will therefore require a higher 10-year rate than a 2-year rate.
Yet, one would think that a bond offering a guaranteed return for 10 years would be preferable to a bond offering a guaranteed return for only 2 years. But it's not. Imagine that inflation accelerates for years to come. How do you know that the yield offered by the 10-year bond will be enough to cover the price increase? Of course, the same could be said of the 2-year bond, except that after 2 years you can always buy another one that will potentially offer a higher yield.
This is why the investor generally demands a soulful premium for the 10-year bond compared to the 2-year bond. Except that today, this is not what is happening: the 10-year rate is much lower than the 2-year rate. So today, the yield curve is inverted and significantly inverted.
From a theoretical point of view, this means that the investor is willing to take the risk of a lower yield for a more extended period, but guaranteed. In terms of expectations, this means that the investor anticipates a sharp decline in short rates over the next few years so that the cumulative return on short rates expected over the period equals that of the long rate, otherwise there would be an inconsistency between the two forms of expectations, which is called an arbitrage opportunity in theorists' jargon.
Finally, from an empirical point of view, it is indeed the case that the inversion of the yield curve has often anticipated an economic recession in the following 6 to 12 months, as shown by the numerous publications on this subject.
Final Thoughts
In conclusion, however, it is possible to qualify the very pessimistic message delivered to us by the inverted yield curve. Indeed, the predictive power of this curve has melted away over the last 15 years, for an identified reason: ultra-accommodating monetary policy.
In concrete terms, when the curve flattened or even inverted, it was no longer due to the anticipation of a restrictive monetary policy that would make 2-year rates rise faster than 10-year rates. The cause of the flattening, or even the inversion of the curve, was now linked to massive purchases of long-term securities by the Central Bank, which caused 10-year rates to fall while 2-year rates were already close to the bottom (the 0% level).
Those who are afraid of the inverted yield curve are therefore implicitly betting that the ultra-accommodating monetary policy is well and truly over. Those who play it down are betting that the Central Bank will never take such a risk.
It's up to you to choose your side!
Some reading
Europe Closes the Crazy Parenthesis of Negative Rates. Could the housing bubble burst?
Do Kwon Says “He Is Not on the Run”, but He Still Tried to Leave With 3,000 BTC. The evidence is more than overwhelming on the guilt of the founder of the Terra Ecosystem.
The Rout of the Pound Revives the Worst Hours of Brexit. Many are already calling for Kwasi Kwarteng’s resignation to save the pound.
Here Are the New Global Routes Followed by Russian Oil to Escape Western Sanctions. The number of ship-to-ship transfers has exploded in recent months.
Two Years After Trump’s Threats, Silicon Valley Tries to Drive China’s TikTok Out of America. Worried about the success of TikTok, Meta leads an anti-TikTok campaign full of bad faith and hypocrisy.
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