Much has been emphasized about the current existence of an inverted yield curve heralding the oncoming of a recession. Does it have merit? What are its counter-arguments?

I won’t pretend to be an expert on the subject matter, nor am I a historian to confirm the truth in the past. However, we always stated that “the past is not a certain indication of the future”. We have to learn to take media information on both sides of the argument with a grain of salt. Draw your own conclusions from what you’ve gathered!

First a definition:

“An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession. An inverted yield curve is sometimes referred to as a ‘negative yield curve’.”

The definition already included what most people are fearing. Historical correlations have much wisdom to offer, however are we comparing apples to apples? Proponents against this theory are citing many economics conditions that lend clarity to why this inverted yield curve is different, due in part to simple supply and demand.

Dividends
More companies are issuing dividends than ever. It is now the hip thing to do! Even the tech sector, an industry not prone to declaring dividend, saw heavyweights like Microsoft making dividend a more important feature of owning their shares. Dividend companies are grabbing marketshare from institutional investors who traditionally invest in long term debt instruments.

Income Trusts
Oil and resource related stocks have been the darlings of the stock market. Many of them operate in an income trust structure. Their attractive cashflow payouts are also grabbing marketshare from invstitutional investors much like dividends have done. Truly, the income investors are now more savvy and have more options than ever.

The Great Budget/Trade Deficit
The Feds’ reaction has been to raise short term interest rates in response to attract foreign investors to buy into the US dollar. Defenders of the inverted yield curve theory citing this will find it hard to compare to previous pre-recession situations (pre 2000). As well, the opening up of a global economical market makes it much more accessible for foreign countries to come to the aid of the Feds.

Real Estate
The real estate boom affecting long term bond yields? Certainly I’m way off course right? Actually this is an argument for the inverted yield curve as a potential catalyst to start the recession ball rolling. Cash strapped home owners, living bill to bill have over-extended their credit means. Consumers cashing in on cheap home equity refinances are now finding it less and less affordable. If it starts sliding, it may be a slippery slope all the way down.

Oil Prices
When we talk about oil prices, we’re really talking about inflationary pressures. The Feds not only have the deficit to contend, but also are responding to the potential strong rise in cost-of-living. Oil prices don’t seem to be slowing down either, causing much worries among the analysts who are siding with the inverted yield curve.

Nobody knows if any or all these factors will continue their course. What I feel is that a stable long term view should be taken for any investor. Even if a recession does happen, it won’t be forever. When you are a contrarian, the prospect of a recession can even be more exciting!

Knowledge@Wharton: Don’t Sweat the Inverted Yield Curve: No One Really Knows What It Means