The Yield Curve Inverted Today — 1st Since 2019 — What It Actually Means

To fully explain this recession warning, the “Yield Curve Trigger” and how bond markets operate would literally take several hours. What my goal of this newsletter is, however, would be to explain in simple terms what is going on surrounding this hot topic in the financial news world. I’ll give you an easy-to-understand scenario of cars traveling down a highway, so that you can visually imagine and understand the dilemma we are in.

The impetus for these warning signs that are “flashing from the bond markets” surrounding yield curves, are indeed related to several of the factors I’ve been mentioning in previous articles. When it all comes down to it, the markets are an extension of how consumers think and what they are expecting to happen in their state, country and the free world. The stock markets have one way of signaling to the world they are about to crash downward, and without going into a long synopsis…they have been flashing a crash signal for months now. The bond markets, likewise, have their own signaling system, which is slightly more covert, indirect, and difficult to understand for most retail investors. I will try to explain this signal and potential trigger now by laying the groundwork on understanding bond-yield terminology.

In your mind’s eye, think of a highway that is one directional and only has two lanes that travel from Southwest to Northeast. Both lanes are separated by say 50 feet of dirt, and cars in both lanes are traveling at about the same speed. In this scenario, let’s say one of the lanes (upper one) represents a bond that will mature in 10 years. The other lane represents one that will mature in only 2 years. About 6 to 9 months ago the separation between the lanes was closer to 100 feet and the top lane (10- year) had a sharper angle toward the Northeast, while the lower lane (2-year bond) maintained about the same simple angle (traveling with a slight angle toward the Northeast). Now, when you look at this above summary, I’ve just explained a “flattening yield curve.” You will hear allot about this when you read financial reports. That is, the separation of dirt between both lanes is narrowing.

In this flattened yield curve scenario, the picture goes back to the average consumer or retail investor. They are uncertain what is going to happen in 10 years, so they park their money in 2-year bonds. Because of the influx of demand for the 2-year bonds, their yields bump up slightly while the 10-year demand drops, along with interest rates being offered. Consumers tell themselves (on average) the world is a scary place, Russia vs. Ukraine, nuclear threat, impending recession from gas prices, and a whole slew of other fears. Therefore, someone may say “if I can get, for example 2% (the actual yield is less), for a 2-year bond, versus tying up my money for 10 years and only getting 2.3% (the actual interest rate varies), then I’ll play it safe.” In a normal, ‘non-fearful’ world, these roads are always separated by a higher margin (lane gap of dirt), and the interest rates (yields) will pay about 2–3% more for a 10-to-20-year bond versus just a 2-year bond. We are not seeing that, and the gap is narrowing, which brings me to the next example below.

Now let’s talk about the real warning sign and what all the financial news service “talking heads” keep crying about — when it comes to bond yields.

The big-bad monster in the room, namely the “inverted yield curve.” Let’s go back to our example above and take a look at the narrowing gap between the lanes where cars are traveling from the Southwest to the Northeast. All of a sudden, the cars in the lower lane (2-year maturity bond) start to veer into the lane of the upper traffic (10-year bond), crossing over the median strip. Once the car completely crosses over the lane above it and creates its own new lane (let’s call it a 3rd upper lane), then you are now looking at a graphical example of the dreaded “Inverted Yield Curve.” In this scenario, the bond world is so worried about the future, that bond yields for just a puny 2-year bond begin paying more than a 10-year (or even 20-year) bond. This signals the warning sign everyone is worried about…which some analysts are saying may only be a few weeks to just a couple months away. There are so many reasons for this situation occurring but suffice it to say, we are on the cusp of it.

This dreaded ‘Inverted Curve’ is an anomaly that seems to occur before every major U.S. recession-depression, so that is why you are hearing allot about it lately on the financial news networks. What few reporters will tell you however, is that when the 2-year car veers into the 10-year lane…then breaks through it and enters its own lane, its not truly an inverted (yield) curve yet. The reason is, that this inversion needs to happen for a while before we can call it ‘real, true and authentic’…not just for 1 or 2 days. In my opinion, the inverted curve (new lane in the above example) needs to be traveled on for at least a month. Then my friends, all bets are off, and the Great Recession or Great Depression can and will occur. The stock market will probably crash while this is happening. If not, you can expect it within 6–9 months after the 4th week of the Inverted Yield Curve’s continuance.

Some financial reporters, market analysts and researchers might tell you something that I believe is blatantly wrong.

They will say that an economic downturn is not guaranteed once the inversion occurs (short term bonds out paying the long-term ones). In my above example, this is only true if the lower car (2-year bond) only crosses over into the new lane for a brief period (1–2 days in my example). If, however it continually stays in its own new lane, then an economic downturn is inevitable. Especially if it remains that way for a month or so. Longer term bonds must never yield (pay) less than shorter term bonds. It is a warning sign that there is something hugely wrong with the financial markets and the world’s geopolitical scene. Its all about fear and where folks want to park their money to at least earn a little interest.

You can thank The Fed and its tight money policies for some of this fear.

Their recent news about ongoing rate hikes is only going to make this “inverted yield” scenario more of a reality moving forward. I feel Jerome Powell (Fed Chair) may be doing the right thing to increase rates slightly; however, telling the world he is going to do it 6–7 times in the next year was really a bad (and frightening) statement in my opinion. He is just begging for the next Great Recession and a prolonged Inverted Curve with his type of verbosity. His inflation curbing actions have greatly helped drop the upward slope of the 10-year note (bond), and similarly helped the lower lane (2-year from the example above) to have a higher slope of travel from Southwest to Northeast. It is just about to “cross-over” and enter the upper lane of travel, so watch out for this. Pray the new lane of travel is brief and the cars return to their own pre-determined (lower yielding) normal lane.