by RodgerRafter

There has been some hype in the media about the yield curve inverting and how that often leads to a recession. I have three main points to make:

First, the yield curve has not inverted, it has been perverted.
Second, the US treasury yield curve has become perverted by huge distortions and imbalances in the greater global economy.
Third, it’s all relative.

With regard to the first point:
The following chart shows the yield curve at certain key points in time:



1/2/01 was when the curve was most inverted before the 2001/02 recession.
6/13/03 was when rates were lowest, during the deflation scare.
6/29/04 was when the curve was steepest, one day before the Fed started its current series of rate hikes.
1/17/06 was when the curve became most inverted early in the year.

When prices change, there is money to be made. It follows that those with the power to move rates have the power to make money for the well positioned. Some might argue that fluctuating interest rates reflect uncertainties in the economic landscape. I contend that large movements in interest rates are controlled to meet the political and financial goals of key institutions. I use the word "perverted" to describe the curve, rather than "inverted" because I think the yield curve is intentionally distorted by the Fed and Wall St. institutions.

Let me suggest that the yield curve became "inverted" because the Fed intentionally tightened interest rates too much during the 2000 presidential campaign to help undermine the Democratic candidacy. With the stock market crashing, the Fed continued to boost interest rates into May and kept them high until after the election. Soon after the election was over, the Fed conducted 2.5% worth of rate cuts in 5 months.

Let me suggest that the yield curve became lowest in 2003 to help stimulate the economy for the 2004 campaign. The stock market had bottomed in October of 2002, but the Fed cut rates another 0.75% to absurdly low levels and stoked fears of deflation. As ridiculous as that sounds in the era of fiat money, the markets reacted to it.

Let me suggest that the yield curve became steepest in 2004 to help stimulate the hedge fund industry as a way to boost Wall Street trading volumes and profits. Short term profits became automatic as fund managers were able to borrow at ultra low rates an invest in any asset class imaginable. Of course this created huge long term risks, as there are always too many managers eager to seize short term profits.

Let me suggest that the curve has become "perverted" now as the Fed desperately seeks to prop up the dollar without wrecking the carry trade excesses of the last 3 years. The carry traders have their backs to the wall, as their borrowing costs have risen and they can’t afford to have bond prices fall on rising long bond yields. Meanwhile, the US government’s debt service has risen to over $400 billion per year. Meanwhile, the mortgage industry is feeling the squeeze as borrowers get scared away by rising rates. Long bond rates must stay low, or the system unravels. Active intervention is needed to override natural market forces.

The 2000-2001 inversion correctly forecast falling short-term rates into 2003, but the current perversion isn’t really forecasting anything, as far as I can tell. One could argue that the curve is calling for an extended period of unchanging interest rates after a few more hikes, but then the entire yield curve would still be too low relative to inflation.

In recent months, interest rates have been allowed to move up gradually. I expect that a rapid rise would break the system, while a slow rise keeps the derivatives markets intact and the dollar afloat. Here’s a chart of the yield curve at various times this year:

The curve has steepened and perverted alternately as pressure has built on long bond yields and then subsided. January 17th, saw the maximum perversion before treasury demand in February and March drove rates up. Now the curve is perverted again, but that may be difficult to maintain. We’ll see how Paulson does as head of the treasury.


With regard to the second point:
My take is that yields are suppressed by artificial demand on the short end and in the 5-10 year bonds and by limited supply on the long end. There may be many potential explanations for this, including:

1. Derivatives underwriters may have high demand for 5-10 year treasuries. There has been an extreme expansion of the mortgage market based on surging home prices, 0% down mortgages and cash-out refinancing. This has mainly been fueled with short term financing and many of the investors in mortgages have sought to hedge away interest rate risk by purchasing interest rate swaps and other derivatives. The underwriters have then sought to balance their own risks by purchasing 5-10 year treasuries. This has had the added effect of keeping mortgage rates down, with fixed rate mortgage rates linked closely to 10-year treasury yields.

2. The Government has created a shortage of supply on the long end. The US government has been seeking to bring down interest expense on the national debt by issuing more short term securities relative to long term securities.

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