Inversion: What Is It & Should You Be Worried?

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The emergence of dedicated business news channels and the 24-hour news cycle mean that investors have become aware of the faddish nature of financial markets. Every once in a while, a concept or phrase takes center-stage, and every talking head becomes obsessed with a topic. Of course, no one thing is usually responsible for price movements, but when the market focuses in on something, it can have an exaggerated effect.

That is happening now, and the buzzword for the next few weeks looks likely to be “inversion.”

That makes now a good time to look at what inversion actually is, and why traders react to it as they do.

The inversion in this case is of the yield curve, a chart that plots interest rates on the vertical axis against the time to maturity of government issued bonds along the horizontal. The normal shape of that chart is an upward slope, as investors generally demand higher annual interest on money that is committed for longer periods of time.

What is being talked about now, and probably will be for a while, is the situation where that relationship reverses and short maturity Treasuries pay more in annual interest than their longer-dated equivalents.

That is not just being talked about now, it is happening. Yesterday, the yield on five-year Notes issued by the U.S. Government dropped to a point where it was below that of two-year paper.

To many people, I’m sure that sounds like a somewhat wonkish, esoteric thing but it has real-life significance because of what it traditionally says about traders’ expectations for economic conditions.

The Fed raises and lowers interest rates based on the strength of the economy. In good times, rates are raised to slow things down and reduce the chances of that strength causing inflation; in bad they are lowered to stimulate growth. If the market is betting on lower rates in the future, the conventional wisdom is they are anticipating at the very least slow growth, if not an actual recession.

From that, it follows that when five-year yields are lower than two-year (as is currently the case), the consensus is that the outlook for the economy is not good.

That sounds bad, but there are two things that should be borne in mind. Firstly, it is an educated guess on the part of traders, but still a guess. Capitalist economies are inherently cyclical, and we have been in a recovery since early in 2009 so it is little wonder that there is a feeling that a downturn is overdue. Add in worries about a trade war, and the anticipation of slower growth looks like logical caution rather than a reason to panic.

Secondly, there is evidence that this time, inversion may not necessarily be caused by worry about an approaching recession. This move has been in the spread between two and five-year Notes, but the one between two and ten-year Treasuries is usually more closely watched, and that spread has been in decline for a long time.

That suggests that what we are seeing is not a sudden panic about economic conditions, but a more fundamental shift in expectations for interest rates. The Fed controls market rates by adjusting short-term interest, expecting that to move along the curve. As you can see though, that hasn’t happened during this cycle of hikes.

There could be several reasons for that. For example, the recession prompted the Fed to make unprecedented moves, cutting short-term rates to effectively zero, while also buying long-term bonds to hold rates lower further out the curve. The distortion of the market that this action caused is still being felt, making it dangerous to read too much into any unusual behavior of the curve now that things are returning to normal.

What that also demonstrated is that central banks have become better at using sophisticated monetary policy to smooth out cyclicality, and a flatter yield curve could just be the market recognizing that.

Still, over the next few days and weeks you can expect to hear a lot of ominous talk about inversion, especially if the current move continues and the spread between two and ten-year Notes turns negative. The uncertainty about the cause of that, however, means that it may not signal this time what it traditionally has. It’ll still probably cause a short-term drop in stocks, but for as long as hard data remains strong, it is not a cause for panic.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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