Yield Curves that Invert in the Night
What's an inverted yield curve and why should you care?
Imagine you have a lemonade stand, and you sell lemonade to your friends. Sometimes, your friends borrow money from you and promise to pay it back later with interest. This is important to you, as many get their allowances on Friday, but some get it monthly and need time to pay you back... they like to drink their lemonade weekly.
If they pay you back next week it is 5% interest, but if they pay you back in a next month it is 10% interest. Normally, when you lend money for a longer time, you expect a little bit more money back as a there is more risk - AND you had to wait longer to get your money back to be able to use it again to buy more sugar and lemons.
But sometimes, something strange happens - there is a weird freaky Friday financing storm, and you charge 10% interest on the money paid back next week, and 5% interest on the money paid back at the end of the month.
That's what happens with an inverted yield curve. The interest you charge for lemonade drinkers creates some strange behaviors. THEY HARD PART IS YOU DON'T KNOW WHAT THOSE BEHAVIORS ARE GOING TO BE, BUT you do know your friends will pay you more next week and less at the end of the month... it takes you longer to get your money back, and a few kids move away (or forget) then you don't get paid at all... so maybe you stop financing lemonade altogether due to losses (but then you have fewer customers)... in other words all kinds of things start to happen and the end result is you have to lay off your sister and you have less money to spend on candy... your business ends up going through a recession... you make it because you have no debt and you can cut back on expenses, and maybe you raise your prices a little to help.
The question is, did the change in the yield curve warn you that a recession was coming, or does it increase the likelihood that the recession will happen?
This is one for the history books... how's it going to play out...
The last times we got this far out of sync, the market corrected by recession, which means less money to spend on lemonade, cars, houses, eating out, etc. but the shorter terms rates come down and the longer terms rates go back up and the freaky Friday reverses itself once again. This is usually great news for mortgage lenders.
Of note, your lemonade stand had no debt, but the girl down the street borrowed money from a bank to build a fancy stand with big signs and electronic ice machines to scale - when she launched her note was at 3%. It's due now and to refinance the stand, the new note is 12%. If she doesn't refinance, they'll take her stand. If she does refinance, her new debt is 4+ times higher than before so she'll have to lay off her brother and raise prices. That means her brother has less money to spend, and her higher prices create more inflation for other kids that want to buy lemonade.
There's a compounding impact...
Mortgage Advisor Tip: The longer the curve stays inverted the more damage that is going on behind the scenes. Big lemonade stands with a lot of debt on them (office buildings, banks, large commercial projects) are likely going to have to walk away, or raise prices, both options put strain on the markets.
