Only two false flags in 65 years…

An inverted yield curve gave markets a scare last week.

Last week markets in America were shocked to wake up and see that their yield curve had inverted.

They were shocked. Nobody likes an inverted yield curve.

Why?

Because an inverted yield curve is a pretty good indicator of recession.

Actually, pretty good is an understatement. It’s excellent.

In 65 years there have only been two false flags.

(Show me an economist with that kind of track record and I’ll put them on the payroll for a million bucks.)

So ofcourse markets freaked out.

Now I don’t want to bore you with too much technical detail, but it isn’t actually that technical a thing.

The yield curve just tells you the rates of return over different maturities.

So if you’re lending money to the government for 1 year (buying 1 year bonds), the government will pay you 1%. At two years its 1.5%. At 5 years its 3% and so on.

It’s a way of looking at the price of money.

But what happens when a yield curve inverts is that the money become cheaper in the long-term than in the short or medium term.

And when the yield curve inverted last week in America, the government was paying you 2.5% if you lent them money for 3 years, and 2.4% if you lent it to them for 10 years.

That is, it became cheaper for them to borrow money for more time than less. This makes no economic sense.

It is a travesty against the laws of economics.

But that’s what we got.

And what it tells us is that markets expect the Fed to hike rates aggressively in the short term, but that they think the Fed will end up breaking something and have to cut rates over the medium term.

That is, the markets are expecting the Fed to muff things up.

And this is interesting in Australia because here markets are expecting the RBA to hike incredibly aggressively. Based on the cost of money across different time horizons, right now, markets are pricing in nearly eleven straight rate hikes by July 2023.

Eleven!

If that were to happen, it would definitely break something. It would break my mind but it would probably break household budgets as well and send the economy spiralling into recession.

So what’s the signal here?

Markets aren’t as confident as the central banks are right now. They reckon something is going to break.

And this should give the Fed (and the RBA) a lot of pause for thought.

And I reckon it will.

Everyone is still betting on rate hikes this year – lots of them.

I’m not sure about that at all.

JG.