795-Point-Dow-Plunge And The Inverted Yield Curve

Peter Cohan
Written by Peter Cohan

If you are seeing the term “Inverted Yield Curve” for the first time, you should know what it means and why it matters for managing your money.

It’s newsworthy because on Dec. 3, the yield curve inverted and today the Dow fell 795 points.

We don’t know what caused stocks to fall (part of the fall could have been due to investors’ mistaken belief based on a Trump Tweet yesterday that his trade war with China was about to end).

But the photo in this post does reveal how dangerous it can be to ignore an inverted yield curve. Back in March 2006, the yield curve inverted and the Bank of Japan expressed confidence that the U.S. economy would not go into a recession.

Two years later, the global economy was brought to its knees.

The yield curve is a graph of interest rates on government bonds by their months or years until the bonds’ principal must be repaid. The yield curve typically shows those rates for the Fed Funds rate (which is very short term), 3-month, 2-year, 7-year, 10-year, and 30-year.

As I first learned when I read William Greider’s, Secrets of the Temple, the yield curve typically slopes upward — with short-term rates lower than long-term ones.

The reason is that when the economy is expanding, investors are optimistic about the future so they are eager to borrow money at low rates and invest it in assets that they believe will grow in value and pay off in the future.

However, as Greider explained so well, the Fed can engineer a recession by raising short-term rates — signaling its pessimism about the future — and in so doing, causing the yield curve to invert.

An inverted yield curve means that short-term interest rates are higher than longer-term ones. The inverted yield curve is what happens when investors are bidding for longer-term bonds — thus driving down their yields — because they are pessimistic about the short-term prospects for the economy.

The most extreme case of this was in the early 1980s when Fed Chair Paul Volcker wanted to rid the U.S. economy of inflationary expectations by hiking the Fed Funds rate up near 20%.

This strategy caused a whopping recession as short-term credit became very expensive and people saw no reason to take the risk of investing for the long-term when they could put their funds in a money market fund and earn a nearly 20% return.

One particular yield curve — the one for U.S. Treasury Department securities — is a particularly powerful predictor of economic conditions. These are sold in 12 maturities — One-month, two-month, three-month, and six-month bills; One-year, two-year,  three-year, five-year, and 10-year Treasury notes. and 30-year bonds, according to The Balance.

As The Balance wrote:

So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yields on those bonds fall. They are in demand, so they don’t need as high a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors. Eventually, the yield on short-term Treasurys rises higher than the yield on long-term bonds and the yield curve inverts.

On December 3, the yield curve inverted a little bit — the first time since the 2008 recession. The yield on the five-year note of 2.83 was 1 basis point (100 basis points = 1%) lower than the yield of 2.84 on the three-year note.

This is investors’ way of saying that the economy will be a little better in 2023 than it will be in 2021.

The Treasury yield curve has been a good predictor of recessions in the past — offering warnings of the recessions of 2000, 1991, and 1981.

But for the 2008 financial crisis, the yield curve was early. The first inversion occurred on December 22, 2005. The Fed was concerned about a housing bubble and started raising rates in June 2004 — by the end of 2005, the fed funds rate was 4.25%.

The two-year Treasury bill yield hit 4.41% — but the 10-year note was a bit lower — at 4.39% — the first inversion of -2 basis points.

The Fed kept raising rates — they hit 5.25% in June 2006 — and by July 2006, the yield on the 2-year note was 5.12% — 5 basis points more than the 10-year note’s 5.07% yield, according to The Balance.

The yield curve stayed inverted for almost a year and it was not until September 2007 that the Fed started lowering the Fed Funds rate to 4.75% — cutting them to zero by the end of 2008.

The yield curve was then upward sloping — but the economy was in free fall.

If we are heading into a recession now, the Fed has little room to cut the Fed Funds rate — after all it’s at a mere 2.25% now. Anyway, we’ll see where they’re at in two years.

History doesn’t repeat itself, but sometimes it rhymes.

This article was originally published in Forbes.

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About Peter Cohan
I ditched corporate America in 1994 and started a management consulting and venture capital firm (http://petercohan.com). I started following stocks in 1981 when I was in grad school at MIT and started analyzing tech stocks as a guest on CNBC in 1998. I became a Forbes contributor in April 2011. My 13th book is "Startup Cities: Why Only a Few Cities Dominate the Global Startup Scene and What the Rest Should Do About It." I also teach business strategy and entrepreneurship at Babson College in Wellesley, Mass. (http://www.babson.edu/Academics/faculty/profiles/Pages/Cohan-Peter.aspx)

Image Attribution: FILE - In this Nov. 9, 2017, file photo, U.S. President Donald Trump, right, chats with Chinese President Xi Jinping during a welcome ceremony at the Great Hall of the People in Beijing. Seeking China’s help on isolating North Korea through economic sanctions, Trump backed off a threat to label China a currency manipulator. He was off-and-on conciliatory on trade during an extended visit to Asia in November, and China announced it would lift restrictions on foreign investment in its banks and other financial institutions. (AP Photo/Andy Wong, File)