E The Inverted Yield Curve Is Actually Bullish

For most of June, only the three-month was out of whack, which we can partially blame on the Federal Reserve’s rate policy. Everything else looked to be a regular, upward-sloping yield curve.

Then one grey day it happened (Jackie Paper came no more.) On August 14, the two-year ticked above the 10-year to create the dreaded inversion. The financial media went nuts. Recession is coming! Recession is coming!

However, within hours, the curve un-inverted. Was recession averted? Did that temporary inversion mean anything at all? And the real question, does a positive 10 basis point spread (0.10 percentage points) mean something all that different from a negative 10 basis-point spread? And if the economy is going to go into the pooper, shouldn’t the inversion last for weeks and months, not just hours?

How it Got There Matters

Just like knowing how a stock got to its current price, we should know how the yield curve got to its inverted state, albeit a temporary one.

I’m not a bond maven but I did notice that the 10-year yield dropped like a stone recently and that is what seemed to have driven the inversion. We’ll get to the why that happened later.

After posing the question to a group of pros, I got the answer from a real bond maven, Michael Krauss, the former Managing Director and Head of Global Fixed Income Technical Analysis and U.S. Equity Technical Analysis at JP Morgan Securities.

It turns out that my observation was right (blind squirrel, I know). It does matter how the yield curve got flat or inverted. What Krauss said was that the steep drop in the 10-year yield and a slower drop in the two-year yield was called a “bull flattener.”

When they talk about an inverted yield curve, most people think of the “bear flattener” variety, where short rates rise quickly and long rates do not. This is where the Fed sees something overheating in the economy or the ugly head of inflation rearing so it clamps down on easy money. This tends to lead to a slowing of the economy and weakness in the stock market.

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Disclosure: No positions in anything covered.

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