IN THIS ISSUE:
1. The Normal Yield Curve & An Inverted Yield Curve
2. Why Is An Inverted Yield Curve So Important?
3. As Usual, The Fed is the Wild Card in All of This
4. Trump’s Tariff Rhetoric is Greater Market Threat
The US economy is booming with GDP growth of 4.2% and 3.5% (annual rates) in the 2Q and 3Q. Consumer confidence has soared over the last decade to near the highest level ever recorded. Corporate profits have exploded this year, thanks in part to Trump’s tax cuts. The unemployment rate has plunged to the lowest in decades at 3.7%.
Yet US stocks, which have soared to record high after record high in recent years, have plummeted in recent weeks. The question is, what is going on? We hear that stocks have sold off for two primary reasons: growing fears about a trade war with China and a yield curve inversion which many believe means a recession just ahead.
President Trump continues to threaten China with more tariffs, but I hope he is he is smart enough to avoid a full-blown trade war with China. We’ll see. On the yield curve front, I’ll tell you why fears of the inverted yield curve are overblown, in my opinion.
Let’s get right to it.
The Normal Yield Curve & An Inverted Yield Curve
Most of my clients and readers understand what the yield curve is. The yield curve is the level of borrowing rates (interest rates) at various maturities. Normally, interest rates rise with the length of borrowing maturities. This makes sense since you would normally require a higher interest rate for a longer borrowing time.
Put differently, if you are a lender, you would require a higher interest rate on a loan with a 10-year maturity than you would for a loan with a 2-year maturity. Ditto for a loan with a 30-year maturity, such as a mortgage, versus a loan with a 10-year maturity. So, the normal yield curve has an upward slope, such as you see below.
Yet in recent weeks, a part of the yield curve has “inverted,” meaning a section of the curve has shorter-term rates rising above longer-term rates, as you can see below. The yields on the 2-year and 3-year Treasury Notes have risen marginally above the yield on the 5-year Treasury Note, which by definition is an inverted yield curve.