Yield Curve Inversion: Geopolitics and the Recent Wild Ride on Wall Street

DC DISPATCH-Last week’s Wall Street whiplash/rollercoaster ride is further evidence that major disruptions in the market have become the norm.

And while we have grown accustomed to volatility in the capital markets, often as a result of the volatile policy directives of one American President, this week’s inverted yield curve -- one of the indicators that a market correction may be looming -- signaled that a long-running bull market may be in decline as capital flees to the bond market. 

Last week, something unusual happened: the U.S. yield curve inverted at two points. This means that the rate of return for buyers of long-term treasuries dipped below those for short-term rates. More specifically, this happened between the 3-month and 10-year treasury bonds and the 2-year and 10-year treasuries. Normally, we expect that when our money is tied up for longer periods; we, in turn, get a higher rate of return or yield. When this is not the case, it is a sign of a dislocation in the markets and broader investor concerns about their future. Normally capital flies to safe havens with the Japanese Yen, U.S. Dollar, and U.S. Treasury bills experiencing a boon. If the investors’ concerns are valid -- or even if the collective psychology prompts a stock market sell-off and decreased consumer spending -- the economy can contract and recession (two consecutive quarters of contraction) could even be on the horizon. 

As part of this stock market recalibration, banking sector shares such as Bank of America and JP Morgan sold off. On August 16, 2019, Bank of America CEO Brian Moynihan affirmed to Bloomberg his belief that U.S. economic fundamentals remain strong. Moynihan stated that the inverted yield curve is largely driven by global concerns and specific sectors of the U.S. economy. "It's largely outside the United States and inside the United States around trade and manufacturing." When Moynihan referred to events outside the United States, there are too many to count. 

Geopolitics are contributing to a global economic malaise and thus impacting the yield curve. Hong Kong authorities just announced a $2.4 billion stimulus package in hopes of reversing woeful growth forecasts and offsetting the consequences of political turmoil. European Central Bank deposit rates are negative. Uncertainties abound with Brexit terms and consequences unclear, and Argentina’s peso plummeting amid fears that Buenos Aires will again default on its debts. In such tumultuous times, the question is whether the United States can protect itself from this worldwide malaise and still thrive. The U.S. is only 20% of the global economy, so its ability to remain isolated from this global weakening is possible, but not likely.

The balance sheets of American banks are indeed in better shape than during the Great Recession of 2008, with both better liquidity and asset quality. After all, 18 banks undergoing the first-tier stress test, a.k.a. the Dodd-Frank Act Stress test, met the standard for survival even in a severely stressed hypothetical economic downturn. However, Bank of America, like all other banks, has its overall performance directly tied to interest rates. They make a great deal of profit by borrowing short and lending long. As the spread narrows and/or possibly inverts, the bank could get caught in a crunch that consumer confidence alone cannot save.  

Consumer spending represents over 68% of U.S. GDP and if that falters, a recession is sure to follow. It’s true that some signs, such as strong 2Q sales at retailers like Walmart, suggest that U.S. consumers remain confident and willing to spend. But retailers in more mid-market segments tell a different story. Macy's reported weakening earnings in 2Q with EPS of .28 cents, missing the consensus estimate of .46 cents. Nordstrom and JC Penney stocks were also down 10% and 6% respectively while Barneys New York has declared bankruptcy.           

The pressure is on the Federal Reserve to prove that the U.S. can insulate itself from geopolitical factors, grow above 2%, and keep unemployment low. With planned meetings in September, there are expectations that several rate cuts are in its future. In theory, the Fed could cut the federal funds rate eight more times from its current 2.25% before hitting the 0.25% benchmark rate -- effectively zero – that it reached after the 2008 recession, where it stayed for seven years. The Fed has also been testing investor appetite for introducing 50-year and 100-year treasury bonds into the market (possibly making it harder to invert). Is this a sign that the Fed also thinks a recession is coming? 

Peter Navarro, the Assistant to the President and Director of Trade and Manufacturing Policy recently stated that "technically we did not have a yield curve inversion." But, given his position, he likely hopes to influence the curve by staying behind and not ahead of it. “An inverted yield curve requires a big spread between the short and long,” Navarro said. “All we have is a flat curve. It’s a flat curve which is a very weak signal of any possibility.” Navarro’s inability or unwillingness to honestly assess the risks of the economic situation, to create a false positive scenario, and to ignore the real distortions of Trump’s trade war with China are extremely dangerous and destabilizing and may themselves affect consumer confidence. 

If a recession hits in 2020, it will be devastating for Donald Trump's re-election prospects. In the past months, Trump's twitter attacks on Federal Reserve Chairman Jerome Powell have increased in their frequency. If the Federal Reserve concedes to Donald Trump and the market by cutting rates, the inversion in the curve would dissipate as short-term rates would decline, but this would only be a temporary fix. More seriously, if the Fed responds to Trump’s attacks, they will have fewer tools to deal with a real crisis and the ever-increasing deficit. 

Rashida Tlaib's 90-year-old grandmother recently said, "May God ruin Donald Trump." She may have her prayers answered by the financial markets first. Decreased consumer confidence, poor manufacturing data, and increased unemployment will likely follow -- a prelude of what's to come, as far as granny Tlaib’s wishes are concerned.


(Sara Corcoran writes DC Dispatch and covers the nation’s capital from Washington for CityWatch. She is the Publisher of the California and National Courts Monitor and contributes to Daily Koz, The Frontier Post in Pakistan and other important news publications.) Cartoon: John Deering/Arkansas Democrat Gazette. Edited for CityWatch by Linda Abrams.