What Does the Inverted Yield Curve Really Mean?

With the level of fretting in the popular press over the fact that the yield curve is inverted, you might be forgiven for picturing Bambi's forest when some rumor starts that MAN has shown up with his thundersticks.

Really, I'm pretty sure that most of the chinwags yammering over the yield curve don't even really know what it is. They believe they're supposed to believe that it's bad, sorta like how people think they're supposed to like pate, Joyce, or anything by Wagner. Hide the women and children, folks! The yield curve, she's invertin', and Driver 8's been on this shift too long.

For the record, here's what the yield curve is:

The yield curve is a single graph that shows what the current interest rate is for U.S. Treasury debt obligations of various lengths. If the six-month T-bill is offering 4.00% (these rate numbers are not actual but for illustrative purposes only), the two-year T-note is offering 4.24%, and the 10-year T-note is offering 4.68%, you can plot these rates and time periods on a graph and then play connect-the-dots. The "normal" yield curve has the interest rate for long-term instruments being higher than the rates for shorter-term paper. There are also times when the yield curve is "flat," which means there's little difference in short- versus long-term rates.

An inverted yield curve is relatively rare and is an event highly correlated with the onset of economic recession, or at least stagnation. Correlation does not necessarily mean causation, however. And though it may signal an upcoming weak period, it also may mean . something else.

Think about it this way: The Federal Reserve has raised the overnight Fed Funds rate 13 times in the past 18 months or so, more than quadrupling it in the process (1% to 4.25%). In spite of this, long-term interest rates have failed to rise much at all.

What an inverted yield curve has tended to mean in past events was that the cost of securing credit was too high, or that lenders were too tight with their capital. This is what happens when recession is upon us: People and businesses become more conservative with their money, since the risk of default at prevailing interest rates is too high.

Most individual investors don't have that much visibility into corporate lending, but go ahead and take a look at the consumer debt markets, including mortgage lending. Would anyone, and I mean anyone, suggest that credit is neither readily available nor still quite cheap? In fact, type in the word "mortgage" into Google, and you get 101 million hits, with Wells Fargo (NYSE: WFC  ) , ABN AMRO (NYSE: ABN  ) , Bankrate (Nasdaq: RATE  ) , and Freddie Mac (NYSE: FRE  ) all on the top page.

Fine, so these companies might all have mortgage listings to tell you that getting a loan is tough, but that's just not the case. Credit is loose and cheap, even to the highest-risk borrowers, so that doesn't explain the inverted curve. In fact, the interest-rate premium subprime borrowers pay is quite small compared to those with better credit, suggesting that capital for lending is plentiful. Lenders like Countrywide Credit (NYSE: CFC  ) and National City (NYSE: NCC  ) are willing to borrow, but see a drop in demand from borrowers. This is a different situation from the prospect of an oncoming recession, which normally occurs because of a credit crunch.

Mortgages are but a slice of the total lending markets, but the situation there translates pretty well across the board. Companies, as well as individuals, make their investment decisions on capital projects, not based on two-year money, but on 10- and 30-year rates, and there's plenty of supply. Maybe too much. There's really nothing the Fed can do about this. Heaven knows they've tried. Given recent Fed comments that they're closer to the end of their tightening cycle, perhaps they've grown tired of trying to "push on a string" and are simply going to allow the capital "froth" to work its way through.

One more thing about Federal paper
Of course, saying that it's different this time is a dangerous thing to do. But there was an event a few years ago that really did make the current situation incongruous with earlier yield-curve inversions. Remember, when we're talking about rates, the quotes are for U.S. Treasury paper. A few years ago, when short-term rates were extremely low, the government stopped issuing the 30-year T-bond. The weighted average maturity of government debt has, as a result, shortened dramatically, while the nominal level of U.S. government debt under the current administration has spiraled upwards. (The Bush administration only recently decided to begin issuing 30-year T-bonds again).

With the end of the 30-year T-bond in Oct. 2001, foreign treasuries that hold enormous capital surpluses with the U.S. -- primarily China, Japan, Taiwan, and Korea -- reinvested their dollar assets into the 10-year T-note. The demand for 10-year T-notes grew to levels nearly without precedent. What happens when demand at these levels rise? You got it - the yield falls. Given the re-issuance of the long bond starting next month, I'd expect some of the pressure on the 10-year T-note to abate, and further anticipate that many foreign buyers of U.S. debt will slide back up the maturity ladder.

When this happens, the yield curve will likely revert to its normal upward-sloping shape. So, in short: massive amounts of liquidity available for lending, massive amount of demand for treasuries, multiyear absence of the long bond. What this looks like to me is a recipe for inflation, not recession.

For related interest rate Foolishness:

Bankrate is aMotley Fool Rule Breakersrecommendation. National City is aMotley Fool Income Investorrecommendation.

Bill Mann is co-analyst for the Motley Fool Hidden Gems newsletter, the leading source of small-cap stock ideas. Like what you see here? Come see what stock ideas Bill and Tom Gardner are ginning up next! A trial subscription is free. No kidding. Bill owns none of the companies mentioned in this article.

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