Why the Yield Curve Inverts in One Simple Picture

Mish Shedlock  |

The yield curve inverts when the Fed keeps hiking in the face of a slowdown.

Bianco research noted today "There has not been one instance where the 2-year 5-year spread inverts and the 3-month 10-year spread didn't."

OK. But Why?

Answer: The Fed kept hiking in the face of a slowing economy as the chart I posted shows.

Thus, whether or not the 3-month to 10-year spread inverts may very well depend on how many more hikes the Fed gets in.

It's possible that that the 3-month to 10-year spread will invert anyway, but it wouldn't have at zero.

Economy Poised to Weaken

Please consider DoubleLine's Gundlach: Treasury curve inversion signal 'economy poised to weaken'.

Jeffrey Gundlach, chief executive officer of DoubleLine Capital, says the U.S. Treasury yield curve inversion on short end maturities are signaling that the “economy is poised to weaken.”
Gundlach, known on Wall Street as the Bond King, said the Treasury yield curve from two- to five-year maturities is suggesting “total bond market disbelief in the Federal Reserve’s prior plans to raise rates through 2019.”

Bond Market Disbelief?

Gundlach's first comment is accurate. His second comment is wrong.

Inversion does not imply in and of itself the Fed will not hike. It does suggest the Fed has already hiked more than the economy can take. Rate hike probabilities provide the proof.

Rate Hike Probabilities

As shown above, the market has a 69.6% chance of at least two more rate hikes in 2019. A month ago it was 87.4%. So the market has started to lesson the odds.

Rate Hike probabilities are from CME FedWatch. The anecdotes are mine.

Inversion Not a Recession Requirement

Let's return to a statement I made at the top: Thus, whether or not the 3-month to 10-year spread inverts may very well depend on how many more hikes the Fed gets in.

Nearly everyone seems convinced the bond market will give its standard recession signal in a timely fashion. That is to say, nearly everyone is convinced the two-year to 10-year if not the 3-month to 10-year spread will invert.

Don't count on it. Japan has had numerous recessions where its yield curve did not invert at all. The US could easily do the same.

Inversion is not a recession requirement.

Mike "Mish" Shedlock

This article was originally published on Mish Talk.

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