Explaining Yield Curve Inversions

The Yield Curve briefly inverted — twice — Monday. As we noted yesterday, the deeper and longer a curve remains inverted, the more potentially significant it is.

That factoid has been overlooked by many commentators. Following yesterday’s post about what an inversion means, it became
apparent that there is alot of confusion about the implications. So far, all we have is a brief inversion — which, for the moment, is merely a warning.

The best explanation I’ve read for what the Inverted Yield Curve may mean to the economy and markets comes from Lacy Hunt, a veteran Wall Street economist who formerly worked at the Dallas Fed:

"There has been a lot written about the flattening yield curve, though most people don’t understand what causes it.

The narrowing spread between yields is a superb leading indicator but shouldn’t be observed in a vacuum — no lone silver bullet can take down the economy. A steep flattening of the yield curve is a sign that the Fed is in the later stages of tightening its monetary-policy belt. It’s part of the broader process. But once it occurs, it does have its own implications for the economy and the markets.

Treasury yields should be viewed in concert with central-bank policy and changes in the availability of money and credit. The Fed influences supply and demand for money when it raises the fed-funds rate, since it pushes up money-market yields. To boost the funds rate, the Fed has to cut down on total reserves — money that banks are required to keep around for backing up deposits.

That reduces how much money can be supplied to people and businesses for borrowing and investing and it crunches the availability of credit that Americans now rely heavily on to keep up their spending habits. Banks’ profits, meanwhile, are crimped because they can’t make easy money by borrowing at low, shorter-term rates and lending at high, longer-term rates — one version of the time-honored carry trade. Higher rates can grind the borrowing and lending process to a halt — or it can reverse, where people pay their loans with money they normally would spend elsewhere. All told, economic growth is stunted.

The yield curve is flattening because Fed policy is working — it’s not a surprise that a higher fed-funds rate is followed by slowing growth in money supply and a narrowing in the spread between short- and long-term Treasury yields. This is clearly evident as 2005 draws to a close: Total reserves fell 4.1% in the past 12 months, and the contraction has happened at a faster pace in recent months because of the cumulative impact of 13 Fed rate increases. M2 money supply — cash, deposits and short-term assets such money-market funds — increased a paltry 3.4% in the last 12 months, the slowest growth in 10 years.

While the flattening yield curve is part of the process, it shouldn’t be taken lightly. This barometer narrowed significantly prior to all of the recessions since 1954, as well as two major business slowdowns in 1967 and 1995. In the middle of those slowdowns, the economy grew at annual rates of 1.6% and 0.9%, respectively. Only quick and decisive Fed action prevented worse conditions. Since 1954, growth in M2 when adjusted for inflation slowed dramatically in the four quarters right before recession. The same thing happened with the slowdowns of 1966 and 1995. That is why both the yield curve and M2 supply are widely considered excellent leading indicators.

Growth of less than 1% in real M2 in the past four quarters, combined with a sharp contraction in total bank reserves, reinforces what the yield curve is telling us: The economy is headed for a slowdown. That means either less inflation, less real growth, or some combination of the two."

I hope that’s not too wonky; it is as clear an explanation I’ve ever read, without dumbing it down too much. Note that the past 4 recessions were preceded by a Yield Curve Inversion, and prior flattenings have predicted a slowdown.


Here’s a chart from today’s WSJ:
click for larger graphic


chart courtesy of WSJ

UPDATE:   December 31, 2005  5:13am

A reader asked for a study on inversions and recessions. Marketwatch reported that Merrill Lynch just released a study (on Friday!) on the subject: 

"The historical record speaks for itself," said Merrill Lynch analysts in a report published Friday.

"In the past 30 years, the yield curve has inverted five out of the
eight times the Fed has been tightening monetary policy. Each of those
five times an economic recession has ensued one year later — our fear
(though not our base case) is that this time will be no different."

If anyone has access to this, please contact me about  sending it.




Examining an Inversion
WSJ, December 23, 2005

Yields on Bonds Invert, Reflecting Unease About Economy’s Future
THE WALL STREET JOURNAL, December 28, 2005; Page A1

Stocks could see rebound on data
Economic data and 4Q earnings to greet the New Year
Jasmina Kelemen
MarketWatch, 5:01 AM ET Dec. 31, 2005

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What's been said:

Discussions found on the web:
  1. B commented on Dec 28

    I simply don’t understand why the Fed is so retarded. Boom/bust/boom/bust. When they have a 100% record of causing a wreck, why don’t they just try stopping a little earlier? Has anyone ever tried biting off smaller chunks with the objective of long term price stability.

    I believe in some powers the Fed has and not some of the other. The markets should set rates on the short end. They are much more efficient than a handful of bureaucrats causing a constant yo-yo.

    Some economists argue the Fed causes inflation. May sound humerous but think about it.

  2. wcw commented on Dec 28

    That’s a little bit like saying sex causes death. It’s true, you’ll get a funny look if you say so at a cocktail party.

    That Lacy piece is nice and clear. Mm, real M2-licious..

  3. JoshK commented on Dec 28

    Isn’t it possible that this is just a reflection of the progress of the FOMC trading desk? They are buying and selling in the government market now to try to “mop up” some of the money out there and raise the rate. It seems to me that all this means is that they have been selling the short end too much and the long end too little. Or falsely counting on that if they work the short end that the market would take care of the long end on its own.

  4. Patrick (G) commented on Dec 28

    In this time period has the yield-curve ever inverted reasonably removed from the start of a recession (i.e. a false positive) ?

    If so, what were the circumstances of those particular inversions ?

  5. B commented on Dec 28

    Maybe sex does cause death. And I quote from Harvard economics professor Mankiw’s book:

    “The problem with the Fed is that it’s actually the cause of inflation.’ According to Principles of Economics by N. Gregory Mankiw, Professor of Economics at Harvard:

    1. The velocity of money (V) is relatively stable over time.
    2. Because V is stable, when the Fed changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P x Y).
    3. The economy’s output of goods and services (Y) is primarily determined by the factors of production and technology and this output is not affected by M.
    4. If M increase more rapidly than Y, then prices rise.
    5. So the Fed is the cause of inflation.

    My point is not to discount something so readily without giving an alternative view some thoughtful consideration. I could quote other economists as well. So, what would the US look like with the markets setting short term rates? Btw, a concept espoused by Steve Forbes more than once. Not that he has the answers but just another validation point that it isn’t so crazy a thought. Worth considering although it will never happen.

  6. JoshK commented on Dec 28


    I thought that the problem is that the Fed (or someone) has to control the issuance of money in order to keep the velocity constant. If the Fed didn’t keep creating more money, we would be stuck with the same M3 as on the first day of the creation of the US currency.

  7. B commented on Dec 28

    Uncle Sammy isn’t sopping any money lately. I hate to give up all of my secrets. But, everyone but retail investors follows all of this data anyway.

    To the contrary, they just injected more money into the system than anytime in the last four years via the Federales open market ops. Started in early November and hit a feverish pace just before xmas. Can you say fuel for our rally? That supports the argument I’ve always agreed with that the Fed will choose the economy over price stability if a choice needs to be made because they are more afraid of deflation than inflation.

    So, they lip us with rate increases while pumping big money into the economy. I’m sure they understand we are on a precipice but who would ever say it? They’d create a panic. I suspect their rate raising fest is creating a dislocation somewhere and they likely know what it is. LTCM, Asian currency crisis, S&L fiasco, etc. Liquidity is too rich globally for them to impact the economy as much as historically possible. So, instead, their rate raisings tend to create a turd somewhere. Or should I say a “floater”? lol.

    My guess is it’s GM. Bond market validation. Stock action, etc. GM needs $12-14 billion to enter bankruptcy……..and depending on how you slice it, that dollar number is coming up quickly. Just a guess. No more validity than Snoopy in the funnies column.

    Conspiracy theorists would have you believe the Feds desire to no longer publish M3 is some big global conspiracy………but there likely is some merit to thoughts but without the cynicism. The Fed is offering more transparency on one hand but wants to remove one of its tools from public view so we actually don’t choke on how much they are pumping money to save us from impending crisis. ie, Inflation is your new friend. And it’s a he(( of alot better than economic crisis or deflation.

  8. D. commented on Dec 28

    Inflation better than deflation?

    I’d pick Japan’s deflationary crisis over the Weimar Republic’s crisis any day!!!

  9. Todd Brill commented on Dec 28

    As I mentioned the other day:

    “Despite the Dire Predications and Prognostications, an inverted yield curve by itself doesn’t mean much except that bond buyers (which are mainly institutional investors) have decided (in all their “wisdom”) that the future isn’t looking so bright.”

    This is in accordance with Lacy Hunt’s statement of:
    “The narrowing spread between yields is a superb leading indicator but shouldn’t be observed in a vacuum — no lone silver bullet can take down the economy.”

  10. B commented on Dec 28

    True and untrue. How’s that for double speak? I could be a politician. The external factors are also looking rather interesting. ie Ugly.

    Btw, Tony Crescenzi, who is also a very capable cookie, has stated that historically the 2-10 yield spread isn’t what we should be looking at. Historically, the best predictor is the 91day/10 year spread which is not inverted. Not that Tony has a corner on intelligence and I have not done the diligence to look at every single historical precedence to confirm that statement.

    That said, we are surely headed for some type of slowdown. Short? Long? Bad? Recession? Depression? Neither? But, if it walks like a duck………..

    My only problem with the worst case scenario is that a perfect storm needs to develop. One in a decades kind of deal if not longer. And predicting the ultimate crisis that may be caused by a dislocation is akin to predicting the next earthquake. May be decades.

  11. JoshK commented on Dec 28


    Sicne the short rate has actually gone up and yields on money markets / repos / short tern notes are up, I have to assume that something is pushing them there. I don’t think that has much to do with the fed borrow window anymore since people are reluctant to use that. That leads me to assume that the FOMC desk is selling a bit of their short term portfolio.

    Yeah, I know the money supply continues to grow. I put in M3 into my BBerg and it is certainly not stopping. But, maybe whoever’s buying the long end is causing that…

  12. kharris commented on Dec 28

    We might also want to think in terms of the real yield curve. The steepness fof the nominal curve from the mid-1960s on includes a non-negligible inflation premium at the long end. The real curve is steeper now than a similar nominal curve would have been in the 1970s or 1980s. To the extent that infaltionary expectations are down from the early to mid-1990s, the same holds for that period.

    The curve isa wonderful thing, but in the same sense that Hunt advises using it as just one tool, I think comparing the nominal curve and the inflation adjusted curve over time is probably a good idea.

  13. spencer commented on Dec 28

    A flattening, inverted yield curve has always been accompanied by a rise in the inflation rate. A great rule of thumb, not perfect but very good, is that we get an inverted yield curve when the inflation rate is higher then the unemployment rate. So we go back to what actually causes the economy to weaken — higher rates or higher inglation, or a combination of the two?

    Historically, the fed tended to tighten until they saw it was working. But since monetary policy works with long and variable lags it meant they tightened too
    much. But this was where Greenspan made a difference in the mid-1990s when he stopped tightening before he did too much damage.

  14. Algernon commented on Dec 28

    Barry, the Lacy Hunt piece is excellent. But again I wish one of you mavens could analyze the exact nature of the counter-vailing liquidity from outside the US.

    Are 10-yr Tres. being bought primarily with genuine savings from Japanese investors or is it more a function of how many Yen are slosing around over there after 12 years of the central bank cranking them out? In contrast to M2, M3 is growing fast.

    My sesnse of it is that inspite of the Fed tightening, the US is pretty liquid. Is it hard to get a loan?

  15. Barry Ritholtz commented on Dec 28


    Exactly — its a buyers market for borrowing. Tthere seems to be very little corporate interest (no pun intended) in taking out loans to expand, invest, etc.

    A robust economy should see increasing — not decreasing — demand for borrowing long rates should go up, rather than down, in those circumstances . . .

  16. A Dash of Insight commented on Dec 28

    Yield Curve — an Indicator, not a Cause

    Understanding the causal relationship is crucial in using any indicator. Lacy Hunt says that reducing M2 growth will slow the economy, but what does this have to do with the slope of the curve? Meanwhile, there was a lot of

  17. Algernon commented on Dec 28


    That’s true. And it feeds my suspicion that the surplus of liquidlity does not flow from savings. China’s money supply grew 14% in the 12 months ending Feb’05 & 18% in the 12mo. preceding that. India’s money supply grew 13% in the 12 months ending Mar’05. Japan with a zero interest rate, etc.

    I think a savings glut would be okay: Human wants & needs are never satisfied & creative people will put those funds to work given time in a reasonably fluid market economy. Excessive Central bank credit expansion leads to misallocation of resources & inflation.

    Lacy Hunt was saying a flattening yield curve implies restriction or tightening of credit. The sense in which it is different this time is that credit isn’t tight.

  18. D. commented on Dec 28


    I don’t think it’s different this time. If credit isn’t tight right now, the flatter yield curve will take care of it in the near future. Banks have been reducing their securities and next to come will be a clean up in loans.

    Malinvestment has been rampant and no matter who’s running the Fed, a cleanup is imminent.

  19. The Big Picture commented on Apr 12

    Did the Yield Curve Send a “False Alarm?”

    So much for the inverted yield curve. Or so says a recent Bloomberg column. If I read this correctly, any inversion that fails to cause an immediate recession is proof positive that inversions are meaningless, the bond market clueless, and data analysi…

  20. A Dash of Insight commented on May 7

    Yield Curve — an Indicator, not a Cause

    Understanding the causal relationship is crucial in using any indicator. Lacy Hunt says that reducing M2 growth will slow the economy, but what does this have to do with the slope of the curve? Meanwhile, there was a lot of

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