Preparing for an Inverted Yield Curve
Sam Park - June 2005
Who's in Control?
Should we stay calm or panic? And should we believe Mr. Greenspan when he
says that the yield curve no longer presages the economic outcome? Let's
assume for now that the yield curve has no predictive value. So, what is the
economic data saying about the current situation? Consumer spending (retail
sales) for May fell further than the consensus expectation. Fluctuating auto
sales and interest rates affected May's negative result; however, the
overall trend shows that consumption is fairly solid. Inflation remains
tamed, and unemployment remains benign.
So where are the major risks? Perhaps the current account deficit and the
federal budget deficit could shed some light.
The above chart (see PDF) shows that the U.S. has faced a current account
deficit for nearly two decades, which continues to grow to record levels.
Our trade relations with export-led countries, such as China and other Asian
countries, may explain and support the ballooning deficits.
Americans love buying everything from cars to clothes, especially when we
find great deals. Our government has also been spending more than it was
able to collect in the recent years (as shown in the chart above). The U.S.
Treasury has had to issue more Treasury debt to finance this overspending.
These excess dollar-holding institutions have looked to Treasuries as a safe
haven for their cash and have been supporting U.S. consumption.
Our government is currently running a deficit after having been in surplus
between 1999 and 2003. Cuts in federal spending plans are shown in the
federal budget estimates and illustrated in the previous chart. However,
this estimate may be overly optimistic, and we believe that they are
"whistling past the graveyard" numbers. Previous to the mid 90's, the
federal budget deficits outpaced that of the current account balance.
However, that trend has reversed as our current account deficit continues to
outpace the federal budget deficit at an accelerating pace.
Several other factors should be kept in mind. Not only has the Internet
created a more efficient pricing, but also these export-led countries offer
cheaper products by artificially depreciating their domestic currencies.
These effects have kept inflation at bay even though we have seen the fed
funds rate rise eight consecutive times.
Asia's Influence on the Yield Curve
It's as if the Chinese authorities have just learned the game of capitalism
and may soon experience the detrimental consequences of continuing their
recent policies. The Chinese government possesses material influence and
investments in (domestic Chinese) private and public companies. Rich Kuslan
of Asia Business Intelligence (asiabizblog.com) asserts that Chinese
authorities own approximately 2/3 of the companies listed on the Chinese
stock markets. These policy makers probably understand that U.S. consumers
represent a large portion of Chinese producers' profits. By keeping the Yuan
weak, and thus their products cheap for us, the Chinese offer cheaper
exports to price-conscientious. However, lower prices may come with the
question regarding quality.
Once these companies receive dollar profits, the dollar ends up in the
Chinese central bank. In the past, Asian central banks have invested the
greenback in dollar-denominated assets such as Treasuries. Richard Duncan,
author of The Dollar Crisis attributes this to explain the falling 10-year
Treasury yields. He believes that as the supply of new Treasuries run out,
so excess investments will go into existing securities. If these
dollar-holding central banks have been buying "off-the-run" 10-year
Treasury, then that would explain their rising prices and falling yields.
Whatever the case, as foreign entities have bought up Treasury notes and
bonds, this has affected the entire fixed-income sector especially mortgage
debt. This effect has further increased the growing housing bubble pressures
as mortgage rates have been dropping again, and thus fueling more property
Yield Curve on the Markets
The previously mentioned pressures have accelerated the flattening yield
curve as the Fed has increased short-term rates to slow the pace of
purchases before they reach unsustainable levels. So what happens when the
yield curve flattens and, as in the past, inverts. The following charts (see
PDF) show these effects.
The blue line plots the difference between the 3-month LIBOR and 10-year
Treasury, which is the proxy used by market participants to determine the
shape of the yield curve. The curve appears steeply inclined when the blue
line peaks and is highly positive. The curve flattens when the spread
reaches zero and inverts when the line goes into negative territory. The
curve will become more inverted as the spread goes further south. The yellow
line shows the spread between the NASDAQ 100 (NDX) and S&P 500 (SPX)
indexes. Particular attention should be paid to the period between 1997 and
the earlier part of 2000.
We can see that when the yield curve inverted between 1998 and 2001, the
spread between the NDX and SPX widened. This observation merits further
investigation. By understanding this occurrence, we can anticipate what is
Impact on U.S. Markets
We know that the shape and degree of the yield curve impacts the debt
markets. Additionally, the yield curve seems to have significant influence
on stock markets. The following charts (see PDF) the NDX and SPX compared to
This graph shows that the spike in the NDX/SPX spread seen between 1998 and
2001 was a result of the tech bubble. Many of the companies listed on the
NDX are composed of technology companies that have helped firms (both
domestic and international) productively and efficiently compete on a global
scale. Such companies include supply chain management software producers and
consultants, among many other service and product providers. Movements in the dollar heavily impact U.S. companies and consumers. Globally integrated companies must gauge the dollar movement to take advantage of currency fluctuation and take positions to stabilize profits. Therefore a look into the dollar index provides valuable insight into what to expect.
The Path of the Dollar
Looking at the Atlanta Fed Trade-Weighted Dollar Index chart below, the
falling Pacific index between 1998 and 2000 seems idiosyncratic. This means
that the dollar became weaker relative to the Asian currencies during those
These indicators weigh the trading influence with major countries, where the
largest trading partners receive the respective weights on the benchmarks.
Japan has the largest weight while China and Malaysia have the least impact
on the Pacific index. Hence, the currently low $/Yuan exchange rate would
not greatly impact this index. The dollar has generally fallen since 2002
and may partly explain the healthy profits to U.S. companies that have
benefited from international exposure. We believe that the weak dollar posed
an opportunistic time for Asian countries to buy U.S. goods and services,
therefore driving U.S. corporate profits coming from abroad between 1998 and
2000. One note to keep in mind is that these indexes do not include India,
who has experienced robust growth. Anther point to consider is the dollar
which has fallen the most against the Euro among the above indicators.
Divergences to Occur
More is revealed about our stock markets when we take a look at the monthly
percentage changes in the NDX and SPX indexes. The chart below (see PDF)
scatter plots the monthly percent changes in these two indexes.
There seems to be a high correlation between the fluctuation in the NDX and
the inverted yield curve. The cluster in the boxes that surround the years
when the yield curve is positively sloped implies a time of less risk and
return. However when the yield curve flattens and inverts, the NDX in
particular becomes volatile, which could represent higher returns for smart
and swift market participants.
What to Do
We are currently witnessing a flattening yield curve. U.S. equity (and debt)
markets have recently been stable; however, this situation may change if the
yield curve continues its downward path. Many fund managers and market
participants could experience a wild roller-coaster ride if the yield curve
inverts. The average investor should avoid attempting to beat the market,
which may become extremely volatile. The markets ahead will be a severe test
of investment professionals many of whom have never been through an inverted
yield curve environment.
We believe the Fed will continue to raise rates at the June meeting to 3.25
percent, further increasing the likelihood of causing an inverted yield
curve. The fed fund futures suggest that Greenspan will opt to take a break
after this meeting in either the August or September meeting. The Committee
is expected to move rates to 3.75 percent by the year-end.
For questions and/or R.W. Wentworth & Co., Inc.'s (RWW) forecasts and
advisory services, contact the following:
Tom Au, Executive Vice President
Sam Park, Senior Associate
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