“Off The Wall” Blog
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I received a lot of great feedback and encouragement on yesterday’s video, and wanted to further dive into two questions that have come up:
- What did I mean by “distortion”?
- Why does a yield curve actually cause a recession?
Interesting to note that the current inversion process is very different from the past. In the past we have had inflation and we’ve had the Fed increasing short-term interest rates to slow down the overheated economy. The change was because of the Fed.
Now what we’re seeing is both the long and short rates falling rapidly, due to people buying our U.S. bonds (both long and short-term bonds). Since our bonds are high in demand, their price is going up which causes the yield / interest rates to go down. It just so happens that the long-term bond yields are going down faster because people are looking for long-term safety in long-term bonds.
This is not being engineered by the Fed or happening as a function of trying to stem an overheated economy–it’s market action.
That is a distortion.
The last seven inversions had the short-term rates rising faster than the long-term rates because of Fed engineering. This time around, the long-term rates are collapsing faster than the short-term rates.
Now, we do not think this changes any of the historical connotation of an inverted yield curve, I’m just explaining what I mean by a distortion by everyone buying bonds versus the Fed causing an inversion by raising interest rates.
Be careful of terminology here…it’s more accurate to say the yield curve precedes a recession rather than predicts a recession.
However, here’s the deal. The distortions and behaviors driven by short-term rates being higher than long-term rates still applies, in our view.
Second question: Why does an inverted yield curve precede a recession?
Well let’s start with how banks make money. Banks lend money to people at longer terms and longer-term interest rates (think mortgages). They’re loaning people money, and people are paying the bank interest for borrowing the money. This makes the loan an asset on the bank’s balance sheet. Then, depositors come in and deposit money with the bank, and the bank has to pay them interest in order to keep their money there. The deposits are technically a liability to the bank. The bank uses the deposits to make the loans. They’re making money on the loans and paying money out on the deposits, so as long as the spread between those two things is positive, the bank is profitable.
When the bank pays a higher rate on its liabilities (ST) than what it earns on its assets (LT), it loses the incentive to extend more loans to businesses and the bank stops lending.
This causes a “credit crunch” which is synonymous with the decreasing ability to get a loan. Businesses then struggle to extend credit to purchasers, and they are forced to downsize and lay off workers. Boom- we enter a recession.
Then what happens?
The moment the Fed engineers short-term interest rates to go back below long-term interest rates:
- The banks can generate a profit again
- Credit expansion will resume
- The stock market and the economy can recover
That’s basically why an inversion in the yield curve is taken so seriously by people. Because of the banking system and the availability of credit.
That’s just a quick explanation. I still maintain that triggers have not been met to classify this as a recession yet…and that could change tomorrow…but I just don’t know and when I know, I’ll sound the alarm.
As we always say, if you need cash in the next 12-18 months (buy a house, retire, etc.), you should probably raise cash now. If you don’t need cash in the next 12-18 months, you’re probably okay just sitting tight and you can talk to your advisor (or us!) for any specific questions.
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David B. Armstrong, CFA
President & Co-Founder
Dave got into the industry when he discovered his passion for finance in his mid-20’s. He’s a combat veteran and served as an officer in the United States Marines Corps on both active duty and in the reserves, retiring at the rank of Lieutenant Colonel. While serving on active duty, Dave was unable to spend money on deployments, so he became a self-taught investor. Along with a few bucks cash as a bouncer, his investing performance grew to be good....
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