Slap from the yield curve can’t be ignored

For the financial world, it hit with much the same violence as Will Smith’s smack to Chris Rock’s face. And it’s dominated discussion to almost the same extent. The topic in question is the yield curve, and its inversion.
The spread between two- and 10-year bond yields has long been regarded as a great indicator of an oncoming recession, and as a phenomenon that can limit the Federal Reserve’s freedom of action. Usually, 10-year bonds will command a higher yield, for the sensible reason that more risk is involved in investing further into the future, and investors require a higher return to compensate for it. Whenever the curve inverts, with two-year bonds yielding more, it’s taken as a signal that a recession is coming, and that at some point soon interest rates will have to come down.
There was a momentary inversion for a matter of seconds, which pundits immediately dismissed as meaningless. But another very strong unemployment report forced an unambiguous inversion.
Unfortunately, we do need to treat this seriously, but also should take note of the very different circumstances in which the curve flipped over this time, compared with the last two significant inversions that started in 2006 and 1998. The bond market has withstood massive intervention over the last decade, and it makes sense that this might dull or distort the signal it sends. However, there has been no attempt by the Fed to invert the curve through their choices of bonds to buy, and at all times the fundamental driver of the yield curve is liquidity — the amount of money surging in and out of the bond market.
There is also a sense in which an inversion is causative rather than just predictive. Tom Tzitzouris of Strategas Research Partners in New York points out that “curve inversions trigger a rationing of capital away from Main Street, and towards Wall Street.” An inverted curve makes lending by banks that much less appealing, while prompting Wall Street to take greater risks, and thus contributes to inequality. Whatever its worth as a predictor, an inverted curve is not good news.
Also, the focus on whether the yield curve indicator is working to some extent misses the point that there are ample other reasons to be worried about a recession, and these have fed into the inversion.
Strange things are happening in the bond market, but it would still be dangerous to ignore the alarm signal. That brings us to the issue of asset allocation. What exactly should you do when the yield curve inverts? Last week saw plenty of sell-side research point out that stock markets tend to rise after a yield curve first inverts. While true as far as it goes, this factoid must be handled with care.
Both times there was indeed some more juice left in equities. But on any medium-term view, it was not a great time to buy.

—Bloomberg