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Statue of Alexander Hamilton, the 1st U.S. Treasury Secretary, outside the Treasury Building in Washington, D.C.

The Real Reason An Inverted Yield Curve Is Such A Bad Sign For The U.S. Economy

Also, Just What The Hell Is An Inverted Yield Curve?

Let’s start with that, because we can’t believe how much incredibly lazy reporting we’re seeing on the biggest single day point decline for the Dow Jones Industrial Average in nearly a year: referring to an inverted yield curve as a “reliable sign of an impending recession”, while not explaining what it actually is. As if you don’t need to know more than that, or it’s beyond the intelligence of a normal person to understand.

Anyway, since we think it’s worth the bother to explain and understand it, we’re going to take our own crack at it. (If you already know how it works, you can skip all the “bulleted” paragraphs. Or read through them anyway with a mind to judge us):

  • The U.S. federal government is the biggest borrower of money. The Treasury predicts it will borrow nearly one and a quarter trillion dollars this year (although those aren’t final numbers, and it’s consistently revised estimates from earlier this year higher). In fact, about half a trillion dollars of the entire federal budget just goes to paying interest on the money the U.S. federal government already owes. That’s only about $100-billion and change shy of the U.S. defense budget, and edging higher, so that some economists predict it will surpass that within the next 5 years.
  • The main way the government borrows money is by having the U.S. Treasury sell securities (a.k.a. government debt), in the form of Bills and Notes and Bonds, which are all basically the same thing. (The different names just denote different lengths of time attached to each of them).
  • The basic idea is when you buy a U.S. Treasury security, you’re lending the federal government money for a fixed period of time, and over that time they pay you a fixed rate. The amount you get, or yield, is not set by the Treasury, the Treasury only says the amount it’s got to sell. The yield is determined at an auction where banks bid on those securities and the Treasury sells to the banks with the bids that allow it to pay out the least amount of interest in order to borrow the money it needs. While individuals cannot place bids in Treasury auctions, anybody with money can buy U.S. government debt directly from the Treasury, just by going to their website and signing up.
  • Treasury securities are considered the safest investments possible. That’s because they have the full weight of the U.S. government behind them. Which really means if the Treasury ever defaults it would almost undoubtedly cause the collapse of the global economy, so a lot of people are going to go out of their way to make sure that doesn’t happen.
  • The Treasury regularly sells securities that last from as little as a month, out to 30-years. Generally, the longer the duration, the higher the yield should be, for the simple fact that you’re agreeing to let the Treasury keep your money for a longer period of time during which you can’t use it for anything else, so they’ve got to pay you for that extra time you’re going to be separated from your money even though they’ll eventually pay you back. That’s what the “yield curve” refers to: the fact that yields generally go up in parallel with how long the security lasts: the longer the duration, the higher the yield. But now the opposite is happening. People and institutions increasingly worried about weakness in the global economy are increasingly buying longer-lasting U.S. Treasury securities. And since so many people want them (not only Americans but also global investors), because they’re considered so safe, the Treasury doesn’t have to pay as much in order to get people to buy them. And so the yield on those longer-term T-bonds or notes comes down. So much so that now the yield on a 10-year Treasury security dropped lower than that on a 2-year Treasury security for the first time in more than a decade, which is the opposite or inverse of what it should be, resulting in an inverted yield curve.

Now, couple things: the financial markets are often moved by the concept that things that happened in the past are likely to happen again. And Wall Street “experts” often like to make bold predictions based on that. Sometimes that’s valid, often that’s BS. For instance, I can predict the Patriots will win the Super Bowl in the next 36 months. Based on the history of the NFL, they will. But there is also a fair chance they might not. (And anyway, if I’m right does that really make me some genius at making predictions?)

So does an inverted yield curve definitely mean there will be a Recession? No. Does one day, or even a couple of bad weeks for the stock market in the middle of August mean our money and jobs are definitely in jeopardy? Of course not. So this could all really mean nothing, right? Yes. Except that in some ways a run-of-the-mill cyclical Recession could be the least of our problems right now. (And reading that back, we realize we’ve said that a little too flippantly: since Recessions do real harm and cause real hardship for all kinds of real people, there really is no such thing as a “run-of-the-mill” Recession.)

In our opinion, at least, the real danger of an inverted yield curve is something else. Because unlike investing in a bank CD, where your money is locked down for a period of months or years, you don’t have that same obligation if you buy a 10-year note or 30-year bond from the government. (The yield on the 30-year bond has also been plunging). No, you can’t really go to the government and ask them to cash you out, but you can sell the bond to somebody else, usually for slightly less than what it’s worth, to make it worth their while.

So buying a 10-year note or 30-year bond today isn’t in most cases a way of investors saying: “this is the best I think I’m going to be able to do financially in the next decade or two or three”. Instead, it’s a way of saying “in the interest of keeping my money secure, I’m going to buy something that I’m probably going to sell at some point (I just don’t know yet when or why), probably for less than what it’s worth”. Now, why the hell would anyone be willing to do that? Only one answer: a perception of security.

And that phenomenon is already happening in many places around the world. Big places. Japan. Some countries in Western Europe. Where interest rates are negative. Meaning you have to pay banks to take your money. The Washington Post uses the example of a bank in Denmark where “investors are…willing to actually lose a little money by lending it to a borrower that is almost certain to pay it back, rather than risk betting on something that could go bust”.

Sounds insane? We would argue it’s already happening in the U.S. for many retail banking customers. For instance, got a checking account that pays little or no interest and make a little mistake that causes you to pay an overdraft or bounced check fee? Or a savings account that pays interest but requires a minimum balance to avoid a monthly fee and then all of a sudden you have an unexpected expense and fall below that minimum balance for a month or two?All of a sudden the bank is getting more money from you because you’re keeping your money there than you’re getting from it. Think the bank doesn’t figure that into its bottom line? Of course it does. So in effect, on those accounts, in those instances — which are many — investors in this country are already experiencing negative interest rates.

And one final note before we leave you today: slower economic growth and negative economic growth are not the same thing, and yet we find them being conflated too in much of what we saw and read today. For instance Germany’s GDP coming in negative .1%, or Britain’s economy actually shrinking by .2%, isn’t the same as China’s economy slowing to a 6.2% growth rate in the 2nd quarter of the year, and industrial production there growing by only about 5%, the slowest increase in 17 years. Germany and Britain at least right now are much worse off.

While bad for China, 6.2% percent growth and a 4.8% increase in industrial production is still good because it’s still growth. It’s still more than it was before, not less. It’s almost triple the economic growth of the U.S. in the same period of time. And a 2.1% economic growth rate for the U.S. isn’t bad because the U.S. is a much more mature economy than China. It also means the U.S. is in much better shape than many global economies. The biggest threats come from manufactured crises like trade wars, and a President who insists America can isolate and insulate itself.

This one day in August may be the beginning of something bad and big, or it may just be a scary jolt in an otherwise generally positive ride. But if nothing else, it proves just how interconnected the global economy really is, and why the President insisting it isn’t is sheer insanity.

The President, as he always does, blames the Federal Reserve, and he’s partly right, they’ve been slow to move. (The recent action makes another interest rate cut by the Fed next month almost inevitable.) Still, if Federal Reserve Chair Jerome Powell’s biggest “sin” has been to err on the side of caution, we’d tend to support him on that. Trump on the other hand Tweets that Powell’s “clueless”. Also, if an economic downturn is inevitable, the Fed needs some room to cut rates when the sh*t really hits the fan, so if it goes too deep too fast it could really get the country into trouble later. And that means it’s always walking an unenviable tightrope with rates already being as low as they are. (BTW Trump nominated Powell — even though he could’ve left the last Fed Chair, Janet Yellen in place — just because, he said: “you like to make your own mark”.)

Written by

Peabody award winning journalist. Streaming media pioneer. Played @ CBGB back in the day. Editor-In-Chief "The Chaos Report" www.thechaosreport.com

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