Why Inversion Is Causing the Gloom Regarding the Future
The concept of inversion has become the topic of gloomy discussions across the stock market. But is the foreboding outlook justified?
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Direct access trading platforms have made online stock trading at lot easier, particularly for new and novice traders. But in the stock market there are some terms or concepts that traders and investors get obsessed with and could perhaps disorient new traders. “Inversion” is one such term. A Look at the Context of the Inversion Discussions Seasoned analyst Martin Tillier, in this article on Nasdaq.com, believes that this term is actually given too much importance, quite like some of the other phrases and concepts. But with traders and investors so obsessed with certain terms and phrases, they could produce an exaggerated effect on the market. Tiller reckons that inversion will be the term of focus for a few weeks now. Inversion, in this case, deals with the yield curve. The yield curve refers to the chart plotting interest rates vertically, on an axis, while the time to the government issued bonds’ maturity is depicted through the horizontal. The normal chart shape is upwards because investors usually demand greater annual interest on money that is held for longer time periods. The point of discussion now in the stock market circles is the possibility of a situation where the above-mentioned relationship between the interest rates and the government bonds is reversed. That indicates that short maturity Treasuries would pay more than the longer period ones, in terms of annual interest. And these fears are not unfounded since Tillier reminds that the US Government-issued five-year Notes yield dropped below the yield of a two-year paper on Monday, December 3, 2018. How the Fed Works Interest rates are raised or lowered by the Fed on the basis of the economy’s strength. When the economy is running fine, the Fed reduces the rates to ensure that the strength of the economy doesn’t cause inflation. On the other hand, when the economy isn’t doing well, the Fed lowers the interest rate to bring about growth. How a Poor Outlook Came to Dominate the Market Now if you find the market believes there could be lower rates, it indicates it is at least expecting slow growth from the economy, even if it may not be a full blown recession. So when you have the five-year yields being lower than the two-year ones, the general market feeling is that the economy has a poor outlook.
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Not as Bad as It Sounds But Tillier explains that though it sounds that bad, it actually needn’t be. Traders have only made a guess regarding the economy. Guesses need not be right, no matter how educated they may be. Tillier reminds us of the cyclical nature of capitalist economies. And since it has been in recovery mode since 2009, traders guess that it is now time for a downturn. The trade war worries have only aggravated to that feeling, and anticipating slower growth therefore appears logical. But Tillier estimates that’s hardly any reason for panicking. There is also some evidence to suggest that the inversion this time may not necessarily be the result of worries regarding any recession that’s approaching. Tillier reckons that it’s not the spread between the two-year and five-year Notes that must be observed, but rather the spread between the two-year and ten-year ones. This spread has been in a state of decline for quite some time, observes Tillier, as the image below by Fred shows:
Distortion Caused by Recession Caused Unusual Curve Behavior We find that market rates are controlled by the Fed through the adjustment of short-term interest, with the expectation that it moves along the curve. But that hasn’t quite happened during this rate hike cycle. Tillier provides an explanation for that. Due to the recession the Fed had to make sudden moves. Short-term rates were cut to nearly zero. Long-term bonds were bought so the rates could be held lower. This caused a distortion in the market, which can still be felt. With things returning to normalcy, Tillier thinks it isn’t safe to take this unusual curve behavior too seriously.
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So this is no sudden panic that we’re witnessing, but rather a basic shift in interest rate expectations. There could be a short-term market downturn, but there certainly is no cause for panic.
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