Inverted Yield Curve – Recession Predictor

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    joe lastra

    I’m trying to wrap my head around why the inverted yield curve is a predictor of coming recession. I understand the yield curve is a relationship between the maturity length of bonds. Once inverted, short term bonds yield higher returns than long term bonds, but how does this predict recession?

    Bank’s easy money policy leads to a boom cycle, when the central bank raises interest rates the money creation slows and the bust happens.

    Why do the feds increased interest rates only affect short term interest rates and not long term rates?

    It seems like the fed increasing interest rate is what causes the inverted yield curve, but why not just say “the fed increasing interest rates is a predictor of a coming recession”?

    What am I missing?



    There are a few theories about the cause-effect connection between inverted yield curves and recessions.

    One is that as businesses feel the financial stress of softening sales while still having a heavy debt load from borrowing for capital projects they borrow short-term as a stop-gap measure in the hope that softer sales will prove temporary. The increased demand for short-term borrowing and decreased demand for long-term borrowing then inverts the yield curve.

    Here is Gary North on the inverted yield curve:

    Bob Murphy emphasizes the Fed’s tightening of monetary policy which raises short-term rates. Tighter monetary policy, then, reverses the asset price inflation from the previous monetary inflation and credit expansion and bring recession.

    Here is Bob Murphy:

    The Fed uses asset purchases to increase bank reserves. Bank reserves are traded overnight in the Federal Funds Market. When the Fed buys securities from banks it pays with reserves, the larger supply of bank reserves then suppresses the Federal Funds Rate. This procedure is why the Fed targets the FFR. So the Fed is directly influencing very short-term interest rates. During the boom, banks use the additional reserves to remain liquid as they expand their loan portfolios across the yield curve. As a consequence it may steepen or flatten depending on where banks expand credit. But during the bust, banks too want liquidity and so the supply of reserves in the FFM dries up the FFR rises. As overnight rates rise, investors arbitrage the supply of other not-so-short term loans into private overnight lending to get the higher rate. This reduces the supply of not-so-short loans and their rates rise. In turn, the demand for longer-term loans dries up as businesses begin to realize they have malinvested and long-term rates moderate.

    The reason investors watch for an inverted yield curve is that the Fed’s rates of monetary inflation vary during the boom. A recession does not follow every slowdown of the rate of monetary inflation, but it does follow every, or nearly every, significant yield curve inversion.

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