You may have heard about a recent development in the money market, the inverted yield curve.

I just wanted to take a moment and try to explain what that is and why you may be hearing about it.

An inverted yield curve is when the short-term interest rates are higher than long-term rates. Normally long-term rates are higher than short-term (think about a 30 year mortgage vs. a 5 yr ARM…..30 year will have a higher interest rate since there is a longer time to pay back the loan, which increases uncertainty (risk) that it will be paid back in full).

Why would you be hearing about this…or care?

There has been much written and discussed on TV about how we are 10+ years removed from the last recession and speculation on when we might enter another recession. A recession is defined as two consecutive quarters of negative GDP growth. The average recession last for about 6 quarters…..so by the time we are told we are in a recession we are likely to be a third of the way through it. Therefore, people have looked to identify forward looking indicators of a recession and a common belief is that the yield curve is a good predictor. The U.S. yield curve has inverted before each recession in the past 50 years. It is generally not immediate, often times it is 12 to 24 months before a recession starts.

What is a Recession (really)?

In succinct terms, recessions are caused when a bunch of people lose confidence all at once.Usually it starts with a mini-crisis. Often times it follows a period where the prices of stocks and houses have been going up for so long that people forget the opposite can happen. This leads to speculation – if you’ve ever heard of someone buying something, not because they actually want it or it produces income, but just because they think it will be worth more in the future, that’s speculation.

Speculation often leads to inflated prices. In the event of a mass loss of confidence, everyone gets scared and rushes out to sell which causes prices to drop rapidly. Folks who are over-leveraged can’t repay their bank loans and they start missing payments.

Banks get scared of losing all that money, so they tighten up lending, which causes business to scale back hiring and expansion – which leads to layoffs – which cuts down on consumer spending – which cuts down business profits – leading to even more layoffs. The problem feeds upon itself.

Eventually, the prices of these valuable assets get low enough that people with actual money perk up and start scooping them up at a discount. This puts a floor under dropping prices. Meanwhile, the Federal Reserve Bank often steps in, lowering interest rates and infusing the system with cheap money to encourages business to expand and soak up the pool of unemployed people. Everyone gets back to work – and spending – and the recession ends….usually in about 18 months.

Any opinions are those of the author and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. Past performance may not be indicative of future results