On Nov. 29, 2000, I wrote about the “inverted yield curve.” This term refers to the phenomenon where investors will receive higher interest for loaning money for short periods than they will receive when taking more risk by loaning for longer periods of time. Normally, those taking more risk expect to be paid higher interest. To be paid more interest for taking less risk is weird — inverted yield curve is the chosen euphemism in the arcane world of bond markets.
Bear in mind, 17 years ago I had only been writing this weekly column for a year, so I barely knew what I was talking about. However, armed with a copy of Ken Fisher’s book of selected charts and graphs, I noticed that an inverted yield curve, more often than not, lead to downdrafts in the stock market and the economy was left teetering on the brink.
As I wrote the column, the stock market had peaked out a few months earlier and had dropped about 12 percent by November — no big deal as corrections go. But within a year, the market had dropped a total of 44 percent from its peak in 2000. The bubble of “irrational exuberance” had finally burst, and one of several holy grails of forward indicators — the inverted yield curve — had offered the glimpse into the future more effectively than any of the others. The others included, just as an example, the Baltic Dry Index, which charts the amount of raw materials being shipped around the globe. Reduction in raw materials leads to fewer products being built and sold. And so on….
That was then. This is now 17 years later. In a recent article, Jeff Sommer in the New York Times chooses for his title: “Clouds Forming Over the Bond Market.” Again, we are entering a period when short term rates are rising, in part, because the Federal Reserve is raising the rate that banks must pay for borrowing Federal Reserve money overnight. Meanwhile, long term rates are set by the bond market’s forces of supply and demand, which has kept long-term rates low. This is because investors don’t see interest rates rising because of inflation — inflation that would only result in response to a rise in economic growth.
This is not necessarily “déjà vu all over again,” because this time “things are different.” The old days when the Federal Reserve could wave a magic wand and interest rates would dance all over the place is not happening today. Banks are sitting on so much cash from depositors who are content to make no money that they don’t need to borrow from the Federal Reserve.
In fact, the Federal Reserve is now letting banks pay back the money they borrowed from the Fed to bulk up their cash reserves during the crash. “Quantitative Easing,” for all its criticism, has done its job and taxpayers were earning over $100 million in interest on the bonds we forced banks to buy in exchange for the cash we made them take. Yes. We “printed money,” at the Treasury Department like we have done since colonial days when necessary, and now we’re getting it back — with interest.
So, today offers a different set of circumstances from what has been the classic relationship between short and long term bond interest rates with more risk dictating higher interest.
We still don’t have an inverted curve yet. The one following the year 2000 occurred in 2006/2007 and we know what happened a year after that. So what concerns economists now is that rates are only headed toward inversion but those who predict the future are always looking at the direction and rate of change rather than the event itself. Applying high school calculus is what economists do to help us avoid surprises. My advice is to assume that surprises are part and parcel of the investment experience and that a conservative mix of investments is the best antidote — coupled with developing a lowered expectation of today’s ever-rising market.