Yield Curve Inversion Can Cause A Crisis Through Reflexivity

The reflexivity theory assumes markets cause changes to the economy instead of merely reflecting changes to the fundamentals. The most recent example of this is the collapse in oil prices from 2014-2015. The oil price decline occurred because of supply and demand issues. However, its decline was also part of the reason manufacturing weakened so much. On an individual company basis, a soaring stock price can allow the company to hire the best workers, have cheap financing, and grow market share. Instead of leading with a great business, a founder can lead with a great idea which isn’t profitable. If the founder can keep investors believing in the idea, he/she can make it happen.

This idea that sentiment drives reality is working in late 2018. Investors are concerned with the yield curve, making it one of the primary factors in our view that’s causing the selloff in stocks. Instead of using the indicator to forecast a recession, investors are selling before the curve even inverts (10 year – 2 year) because they think they know what will happen next. When everyone knows about an indicator, it can either cease driving alpha or speed up the process. Instead of forecasting a recession in over a year, it is causing weakness now.

As you can see in the chart below, the number of Google searches for the yield curve has exploded recently. That’s way more than when the curve inverted in 2006-2007. That’s the only other cycle we have search data on.

Yield Curve Searches

 

Source: Google Trends

Even though the 2 year yield being higher than the 5 year yield hasn’t historically caused problems, there never was a situation where so many investors, alongside the media, were glued to the curve and believed it causes problems.

Banks Too Scared To Lend After Inversion

Adding fuel to the reflexivity issue with the yield curve is banks have stated they will tighten lending standards if the curve inverts. To be clear, since banks lend long and borrow short, their margins are hurt by a flattening yield curve. We’re saying the curve is causing its normal problems and inspiring fear. This fear causes investors to sell their stocks, banks to pull back on lending, and consumers to spend less and save more.

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