Troubling Case for Inverted Yield Curve

I don't want to write this column about the potentially inverting yield curve for two reasons:

1.) I might be wrong.

2.) I might be right.

But bear with me for a moment on this contrarian thought about the bond market.

Ordinarily, when the Treasury yield curve inverts, it occurs because the short end chases the longer end up, with the longer end moving up at a slower pace. Eventually the short end gets close to the long end, and the Federal Reserve stops tightening. Sometimes the Fed goes beyond that level of the long yield when inflation seems to be a serious threat, and the curve inverts. (One note: For this column, I will speak only in terms of yield, not price.)

An inverted yield curve is never normal, but that is the "normal" way an inversion happens. But has the yield curve ever inverted with long rates falling? Not in modern economic history, which for me is since Bretton Woods ended and we went to floating currencies.

But I think the curve could invert, and that it could do it "the hard way." I don't know if it is likely, but it would take two factors to make it happen: a Fed stuck in tightening mode, and foreign central banks that are forced to recycle dollars into Treasury notes because they are forced to by neo-mercantilists who have some political control over them. Both of these factors may be in play now.

I don't like being wrong, but what happens if I'm right? All sorts of relationships get out of kilter in the derivatives markets when the yield curve inverts, and there is a genuine possibility of some hedge funds that got "too clever" with their math blowing up.

Beyond that, banks will have a hard time growing earnings, unless they have a strong mortgage component. Even then, with the curve inverted, securitization tends to "gum up" because a positively sloped curve is almost required for a lender to clip profits in originating a securitization. Loans would either be sold as pass-throughs, meaning they'd be bundled together as a pool, akin to mortgage-backed securities, or MBS; or they would have to be warehoused, letting the originator hedge the interest rate risks until the curve is normal again. That requires having a strong balance sheet, or at least being able to rent one.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

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Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.