Barely anything changes, yet everything changes overnight.  This is what it felt like watching the financial media on Tuesday, December 4, 2018.  Out of nowhere, it seemed like everyone in the financial world was talking about interest rates, or more specifically, the yield curve.

Why now?

I have been writing about the yield curve quite a bit over the past 6 months or so.  The reason is that the yield curve has been flattening, and this is a classic (i.e., reliable) indicator of a coming recession.

The Fed has been gradually raising its target federal funds rate.  Long-term yields have gone up, but short-term yields have gone up faster.  Short-term yields were near zero for quite a while, so it isn’t surprising they have gone up.

The 10-year yield went above the 3% mark over the last couple of months.  It seemed it was going to stay above 3% with the likelihood it would rise more.  The 10-year yield is closely tied to mortgage rates, so refinancing has slowed considerably.  Some people may have felt some urgency in buying a house because they thought mortgage rates would continue to rise.  That narrative is now being questioned.

As I write this, the 10-year yield is once again below 3%.  But the short-term yields have not retreated and are continuing the rise, meaning that the spread between long rates and short rates has narrowed.

On Tuesday, the markets were spooked.  The 2-year yield and the 5-year yield narrowly inverted.  Everything seemed to happen at once.  Stocks plummeted, while longer-term rates also plummeted.  This means that long-term bond prices rose.

It isn’t clear if stocks sold off because of the flattening yield curve, or if the yield curve flattened because of falling stocks.  They seemed to feed off of each other.

The U.S. markets got a break on Wednesday because the state had to pay homage to one of its own. Perhaps there is some irony in the Bush family closing down the trading markets.  It seems a fitting legacy for the man who believed in voodoo economics.

We obviously don’t know for sure where the yield curve will go from here, but it seems more likely that it will invert in the somewhat near future.  I don’t count it has having inverted yet.  I look at the 3-month yield versus the 10-year yield.  There is still a spread of about 50 basis points (0.5%).

Perhaps the yield curve made headlines because the intermediate-term yields slightly inverted.  It also helped that the Dow fell 800 points, although I was already seeing the yield curve headlines at the opening of the day.

Is Recession Closer This Time?

In the past, the inverted yield curve has signaled recession, but there has typically been a lag.  If you wanted to short stocks, it was better to wait 6 months or a year until after the inversion.  The yield curve actually inverted in 2006, but we didn’t see the worst of the financial crisis until September 2008, although the official recession did start long before that.

The bond investors have tended to be ahead of the game.  That is why the yield curve is such a great indicator.  There aren’t many trends in the financial markets that act as predictors this reliably.

In our day of the internet, news travels a lot faster.  It is also seen by a lot more eyes.  In the past, the only people who knew about an inverted yield curve were those watching CNBC and reading the Wall Street Journal, and even they may not have known.  I’m exaggerating a little, but I hope you get the point.  Today, there are many casual investors, or even just people with a 401k who are curious about the markets, who will see the headlines on their favorite financial website.  I don’t know for sure, but I don’t think there was this much awareness about the yield curve and its implications in the past.

Of course, as with anything, there are a few people who are saying, “This time is different.” That is a classic line, which usually means things won’t be much different.  They are never exactly the same, but history tends to rhyme often enough.  Why would an inverted yield curve be any different this time?  Why would bond investors all of a sudden get it wrong as compared to everyone else?  Why would people be locking in long-term rates if they expected a booming economy ahead?

If anything, I could see a quicker onset of a recession.  More people, especially investors, are aware of the dangers of an inverted yield curve.  Some people will see the inverted curve and still not sell their stocks. There are always people who just won’t take action, even though they know they should.  But on the margin, we have to believe that some investors are going to start selling to at least get to a more conservative portfolio.

The problem with indicators is that even if they are true, they cease to be true once they are common knowledge.  Let’s say there is a company that sells winter-related things, such as snow boots and jackets. Once the beginning of February hits, sales start to fall off.  The stock price of the company starts falling too.  This starts happening every year around the first of February. Then investors become aware of this trend, so they start selling the stock in mid-January.  This becomes the new trend.  Eventually, the trend just ends.  Investors know that sales will fall off in February and start back up again around September.  The stock price becomes less volatile as market information becomes better known.

The question is, why this hasn’t happened with the yield curve?  We don’t see recessions that often, but there have been enough of them in our post Great Depression country.  At what point do investors start figuring out that an inverted yield curve means a likely coming recession and a likely fall in stocks? Instead of a one-year delay, why doesn’t this speed up due to learning from the past?

I don’t have a good answer for this, but I am just offering the possibility that maybe things are speeding up.  Maybe investors are wising up to the past with regards to the yield curve.  When the curve does invert this time, maybe the major selloff will being right away.  Or maybe we will already be part way through it.  After all, stocks have taken a big hit over the last couple of months, but the yield curve has not yet fully flattened.

My conclusion is that I have no idea what will happen this time, but that it is good to be prepared for a quicker onset of a recession.  We may not get 6 months or a year warning from an inverted yield curve until a recession begins.  When the yield curve inverts, we may already be in a recession.  It would be wise to prepare for this possibility.