This is getting ridiculous! Every few months, it seems, there’s some new threat to our economy. Hurricanes, rising interest rates, record energy prices — it’s always something. Yet the economy just keeps on growing, and Dow Jones Industrial Average index (INDEXDJX:DJI) just keep on making new highs.
Now it’s yet another threat that has the bears licking their lips in ghoulish anticipation: the inverted yield curve. And my answer to the bears now is the same as it’s been for the last 2 years of a booming economy and rising stock prices: Let the good times roll.
The Yield Curve You Say?
In case you don’t speak economics, the yield curve is just a way of describing the pattern of interest rates on bonds of various maturities. Normally, long-term interest rates are higher than short-term interest rates.
An inverted yield curve occurs when that typical relationship gets turned upside-down; in other words, when long-term rates are lower than short-term rates. U.S. government short rates rose above the yield on 10-year bonds, according to U.S. Treasury data for Oct. 18, 2022. The situation is pretty unusual, because normally bond investors need to earn an increasingly higher yield to compensate for the risk of tying up money for longer periods.
So what difference does it make to you whether the yield curve is right-side up, upside-down or sideways? Fair question.
According to the bears, an inverted yield curve is an indication that a recession is coming. They point to the inversion that started in 1978 and ushered in the back-to-back recessions of 1979 and 1981. The inversion that began in 1988 presaged the recession of 1991. And the inversion of 1999 foretold the recession of 2000.
On the face of it, all that makes it appear like the bears have an open-and-shut case. It seems that recessions follow yield-curve inversions like sunrise follows the rooster’s crow. And, of course, that’s the bleak version of reality that the relentlessly negative media has been pushing.
But take a deep breath and count to 10. Things aren’t as bad as they seem.
One thing the bears don’t tell you is that the yield curve’s track record as an economic crystal ball isn’t perfect. It inverted in mid-1998, yet no recession followed. In fact, the years following that inversion were an amazing boom.
Crowing roosters don’t cause sunrises, and inverted yield curves don’t cause recessions. They can’t, or else why was there a boom following the 1998 inversion? That really shouldn’t be a surprise. Why should there be a recession just because long-term rates are lower than short-term rates?
One of the often-heard answers to that question is that banks have to pay short-term interest rates to their depositors, and so they can’t make a profit on long-term loans if long-term rates are lower than short-term rates. So they won’t make long-term loans, and the economy grinds to a halt.