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Inverted Yield Curve

Their is an old saying that "Every time there is an inversion of the yield curve, problems have followed."

I would pay more attention to the yield curve than anything else in monitoring economic activity.

The big problem with an inverted yield curve is that it puts pressure on financial intermediaries such as banks. This, in turn, puts pressure on the financial markets. All hell broke loose in 1998 when the long bond yield fell below the then 5.5% federal funds rate.

Banks borrow short and lend long, so when short term rates are higher than long term rates, it squeezes their profit margins.

The stock market tanked in 1998 when the long bond's yield dropped below the 5.5% federal funds rate.

We probably would have had a recession if the Fed had kept the federal funds rate at 5.5%, but it didn't. It dropped it to 4.75%, equities recovered, and there was no recession.

In the early 1980s the Fed was faced with the problem of double digit inflation. The solution to the problem of double digit inflation, unfortunately, required a recession.

The discount rate on 91 day treasury bills was above the long bond rate from October, 1980, through September, 1981. The 1981-82 recession followed.

Wednesday the long bond closed with a 5.80% yield, above the 5.75% federal funds rate. Two, five, and ten year treasuries all yield more than the long bond. Sometimes the one year treasury bill yields more than the long bond. We are close to the edge, but not over it. Today the Fed is trying to slow the economy down, not cause a recession.

Remember that we have had two crashes in the last century, 1929 and 1987.

In September, 1929, the discount rate was 6% and the long bond was at 3.7%. The discount rate was 230 basis points above the long bond rate, putting the squeeze on the borrow short, lend long crowd (financial intermediaries). The stock market crashed the next month.

At the end of 1986, the DJIA was 1895.95. It subsequently went up 43.59% to peak at 2722.42 on Aug. 25, 1987. The market crashed less than two months later.

What broke the market was the drop in bond prices, resulting in the long bond yield rising by 200 basis points.

You had a sharply rising stock market coupled with a declining bond market. It was not a stable situation.

I would be somewhat bearish right now. The long bond is now 20 basis points below the Fed's 6% federal funds target rate (the Fed rate being 5.75% with a tightening bias to 6.0% predicted).

In 1999 the Dow rose 23.35% from its 1998 close of 9181 until it peaked at 11326 in late August. Currently it is around 11100. Bond prices have dropped this year resulting in yields remaining static. The rise in stock prices and decline in bond prices this year is not close to the size of the moves made in 1987 prior to that crash.

Mind you, in 1987 you did not have an inverted yield curve. My premise is that they diverged too much in 1987, setting the stock market up for a crash.

In 1994, the DJIA went from a 1993 year end close of 3754.09 to a 1994 close of 3834.44, an increase of 2.14%. The long bond went from a December, 1993, average yield of 6.27% to a December, 1994, average yield of 7.97%, a rise of 170 basis points. Stocks and bonds moved in different directions in 1994, but not to the degree that they did prior to the crash in 1987.
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