The Economy

Will Inverted Yield Curve Invite Economic Chaos?

Some experts say markets are in for a nightmarish ride; others believe the yield-curve inversion won't trigger an economic crisis, as past inversio...
David McCannAugust 14, 2019

Wednesday’s yield curve inversion seems to have brought into clarity what some experts thought should have already been clear: at the moment, they say, the world economy is looking like a mess. Others, though, believe the inversion will not this time be the harbinger of recession that it’s been several times in the past.

Until Wednesday there had been relatively little media buzz about the narrowing spread between the yields on 2-year and 10-year Treasuries. The moment they crossed paths, that changed in a hurry.

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Ted Bauman, an economist and senior research analyst at investor-information provider Banyan Hill Publishing, contacted CFO Wednesday morning.

“With so much attention focused on President Trump’s tweets and their day-to-day impact on the stock market, it was easy to miss the bigger picture of weakening global growth,” he said.

As evidence of that weakness, he first pointed to the following:

  • China’s industrial output is currently the weakest it’s been since 2002.
  • Germany’s exports are plummeting.
  • The eurozone recently suffered its biggest drop in industrial production in three years.
  • Money is flowing out of emerging-market bonds as investors worry about the impact of a strengthening dollar on their finances.

“All of this significantly raises the likelihood of a recession in the next 12 months,” Bauman said. “It’s usually difficult to pinpoint the specific causes of a recession, but in this case, they’re obvious.”

Further, he observed, the U.S. government is in a state of chaos and paralysis, and the U.K. is “hurtling toward an unwanted, no-deal Brexit that’s likely to lead to political chaos” in that country and a significant economic impact on the eurozone.

Want more? “The world’s two biggest economies are at each other’s throats with no obvious prospect of a resolution,” Bauman said. “The threat of war hangs over the Persian Gulf. Hong Kong is in a state of incipient revolution, and China’s People’s Liberation Army is poised to invade.”

In an environment like that, prudent companies hold back on their investment plans, he pointed out. “That cascades through the economy, putting downward pressure on exporters in countries like Germany and China. That, in turn, puts downward pressure on suppliers in other economies, including suppliers of components and raw materials in emerging markets.”

In other words, he concluded, we’re seeing an investment strike by global business in response to accumulating political disorder around the world.

“That’s not a problem that monetary policy can solve,” Bauman said. “And with the political systems of key countries in various states of disarray, there doesn’t seem to be a short-term solution.”

Like it or not, CFOs must be prepared not only to substantially reduce their own investment but also for a potentially devastating hit to shareholder value. Investors on Wednesday, apparently in hysteria over the yield-curve inversion, frantically sold shares and sent the Dow Jones Industrial Average tumbling 800 points by the close.

Gerry Frigon, president and chief investment officer at Taylor Frigon Capital Management, lamented such typical shareholder behavior. 

“Research suggests that investors make most mistakes after downturns, which is akin to jumping off a ship in the middle of a hurricane,” he told CFO. “If they based strategies not on timing cycles but on the real source of most of the wealth created in the past 100 years — owning shares in successful businesses for years or even decades — then they should both expect interim volatility and be prepared to weather it.”

In the short run, Frigon noted, powerful forces can move stocks around the way hurricane winds toss debris. Short sellers can tear down the price of a company regardless of how solid its long-term business prospects are.

“But investors do have one advantage over such fast money: the ability to wait,” he added. “Short sellers and other players who rely on leverage and borrowing, such as hedge funds, can’t sell a company short for years on end; the nature of such trading is necessarily short-term.”

The timing of the stock market’s collapse was great for Jim Collins, a professional investor and Forbes contributor who in July started a new asset management firm, Excelsior Partners, to take short positions on stocks.

He pointed out in a Forbes article on Wednesday that the inverted yield curve sets the stage for a falling inflation rate. While that’s not a bad deal for consumers looking to finance large purchases, it’s “a horrible, terrible, awful thing for financial institutions,” he wrote.

“The global economy in 2019 is based on access to credit, and it has been for the past 50 years,” wrote Collins, who is not the well-known business consultant and author of the same name. “This is what we should have learned from 2008. Jamie Dimon’s balance sheet at JPMorgan is much more important than the one based on your household’s financial situation.”

Amid the tumult, some observers suggested that, despite the consistency with which yield-curve inversions have preceded recessions, it may not be the case this time.

One such optimist was former Federal Reserve chair Janet Yellen. “There are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields,” she told Fox Business Network.

Another recession skeptic, who contacted CFO on Wednesday, was Nicholas Juhle, research director at Greenleaf Trust, a wealth management firm.

“The headlines would have you believe that a global recession and accompanying 2008-style financial market Armageddon are imminent,” he said. “While we agree that recession risks are higher today than they were 6 to 12 months ago, we believe the onset of recession in 2019 is unlikely and see the potential for economic expansion to continue into 2020.”

Global growth has decelerated from 2018 highs, but consensus forecasts are calling for better than 3% global growth in 2019, Juhle argued, adding that Greenleaf is forecasting real GDP growth of 2.0% to 2.5% in the United States this year. The U.S. consumer is gainfully employed, confident, and spending, he noted.

“Business confidence and fixed investment spending have been softer, but that is largely reflective of the uncertainty associated with the trade war,” he said.

Juhle reasoned that heading into the 2020 election season, President Trump likely has two priorities that right now are at odds with one another: (1) keeping the economy and markets healthy, and (2) staying tough on China.

The president is balancing his efforts with respect to these priorities, he added. “He has demonstrated a willingness to turn up the heat on China as long as the market is behaving. When investors become too anxious and begin selling, the heat is dialed back. We believe a negotiated deal will materialize eventually, but as long as the market will bear it, Trump is unlikely to put this to rest before the 2020 election.”

Juhle further pointed to the Federal Reserve’s recent interest-rate cut and the fact that other central banks have either eased their monetary policies or are expected to.

“President Trump has not been shy about his desire for the Fed to cut rates further and faster to spur economic growth, and perhaps stoking uncertainty about the eventual U.S.-China outcome is a means to that end,” he speculated.