The Debts of the Spenders: The Dangers of an Inverted US Yield Curve

Economists and traders believe that inverted yield curves are a sign of impending recession. It is possible but rare for the longer end to have lower yield than the front end of the curve. Potential causes include direct US Federal Reserve intervention, Chinese and Japanese sovereign buying, and finally yield chasing by funds. It is this last point that I want to bring my attention towards.

In theory, lower yields are supposed to push businesses towards renewed economic activity by lowering their borrowing costs. The private sector is then able to finance expenses like plant and equipment, back office updates, and labor costs more cheaply than if rates were higher.

Unfortunately, reality is a different story. Generally, the US business sector remains leery of renewed spending and has instead slashed costs to the bone by enacting their own fiscal austerity measures - firing unnecessary workers, gutting expense accounts, and deliberately slowing payment to creditors while pushing for timelier payments towards their own customers. This is a normal reaction to a recession.

Instead of pushing business borrowing up, the current easy monetary stance is pushing speculators to borrow money at lower short-term interest rates and invest it in higher return assets - either in equities (which is Bill Gross' latest argument) or higher yielding debt (such as private sector high yield, emerging market bonds, or Greek government debt). However, because the buying mandates of many institutional funds require managers to buy investment grade only, they will inevitably turn towards longer dated US government debt. This effectively puts upward pressure on short-term rates and downward pressure on long-term rates.

The end results will not be pretty when rates do rise. Whoever bought all this high yield debt will lose a lot of money . . . even comparatively speaking if they were to hold until maturity.

My final cause of concern is that Bernanke himself believes that inverted yield curves are nothing to worry about. Bernanke has been wrong about a lot of things so whenever he's championing a particular idea I tend to be suspicious about it. When Bernanke made this speech it was in 2006 - then the height of the credit bubble. Well, we both know what happened in the 4 years since then.

http://www.federalreserve.gov/newsevents/speech/bernanke20060320a.htm