Yield Curve Inversion

The yield spread between the 2-year and 10-year Treasury Note has narrowed to 25 basis points, its smallest spread since 2007. This has many investors worried the narrowing spread will lead to an inversion of the yield curve (when short-term rates exceed long-term rates) – which throughout history has often occurred prior to a recession.

In reality, an inverted yield curve simply means long-term investors expect short-term rates to fall in the future. A 2-year bond is just two 1-year bonds, one after another. So if the 2-year yield is below the 1-year yield, then investors are saying the yield on the 1-year bond, one year from now, is expected to be lower.

For the record, an inverted yield curve does not cause a recession. Typically, the yield curve inverts because the Fed drives short-term interest rates too high and over-tightens monetary policy. It's this tight monetary policy that causes the recession, the inversion is a symptom of the bigger issue. Investors, realizing the Fed is too tight, push long-term rates down because they expect the Fed to reduce short-term rates in the future. It's the overly-tight Fed that causes both the recession and the inverted yield curve.

This is why we do not believe the current narrowing yield spread signals looming recession. The Fed is far from being tight. Short-term rates remain well below the pace of nominal GDP growth, and even below many measures of inflation. As a result, rates are likely to rise in the future, not fall. If anything, the 10-year Treasury note appears overvalued – possibly in a bubble (meaning yields on the 10-year Treasury are far too low).

But just like most overvalued markets, investors seek ways to justify it. In 1999, despite weak - or no - earnings growth, the US stock market became massively overvalued. By our measures, over 60% above fair value.

This has now apparently happened to the Treasury market. Justification for low yields include low foreign yields, an imminent recession, and a belief the Fed is (or will soon become) too tight.