What Causes an Inverted Yield Curve
Inverted yield curve happens when short-term rates are higher than long-term interest it has a perfect record of predicting a recession.
We hear a lot of talk in the financial press and on Wall Street about the potential for the yield curve to invert. And if it does, will that signal a coming recession?
An inverted yield curve happens when short-term interest rates are higher than long-term ones. Today, the two-year Treasury yields 2.611%, while the ten-year yields 2.864%, or just .25% higher, making this the flattest curve since 2007.
Some on Wall Street Say This Time it is Different
Even though an inverted yield curve has just about a perfect record of predicting recessions, some believe that, because of the Federal Reserve’s unprecedented involvement in the economy, this time it will be different.
The Fed owns $2.4 trillion of Treasuries and $1.7 trillion of mortgage-backed securities. Starting in October 2017, reducing its involvement in the economy, the Fed began to cut its balance sheet by not reinvesting all of its maturing bonds.
There is no reason though that reducing the balance sheet alone should invert the curve.
Reserves Aren’t the Issue
Because of the extraordinary program called Quantitative Easing (QE), the Fed’s balance sheet went from $864 billion pre-financial crisis to $4.3 trillion today. Most of the assets are bonds; $2.4 trillion of them are Treasuries, and $1.7 trillion are mortgage-backed securities (MBS).
Reducing their holdings of Treasuries has no impact on bank reserves; only decreasing their holdings of MBSs does. Moreover, so far, the Fed has just cut its MBS holdings by around $50 billion. Yet somehow some people on Wall Street and in the press are already recommending that the Fed halt its balance sheet reduction because of a drop in reserves. 
They Were Already Dropping
Excess bank reserves a by-product of QE peaked at almost $2.4 trillion in April of 2014 and started falling before the Fed began reducing their balance sheet.
Currency in circulation was around $1,270 trillion when excess reserves peaked. Today, it is $1,672 trillion, an increase of about $400 billion. When money goes up, reserves go down as banks exchange their reserves for currency.
So, over the past four years, while the Fed’s balance sheet was increasing, reserves were falling by nearly $800 billion. Half of that drop happened because the banks and the public decided they want to hold more cash. The other half because by owning so many bonds, the Fed transferred roughly $100 billion a year in interest to the government’s checking account as money moved from the bank account of the public to bank account of the government by way of bank reserves.
What About the Fed Funds Rate?
Others predict that a collision between the fed funds rate and the interest rate paid on excess reserves will force the Fed to stop shrinking their balance sheet or raising the fed funds rate.
The Fed tries to influence the direction of interest rates by changing the rate at which banks borrow money from other banks. Before the financial crisis, banks received no interest on reserves, so they only kept what was required by law.
Today, with $1,862 in excess reserves, compared to around $46 billion pre-financial crisis, to raise the fed funds rate—i.e., the rate at which banks borrow from other banks—the Fed must pay banks interest. If not, banks would lend them to other banks, causing the fed funds rate to fall.
Some fear that some banks are borrowing reserves to earn an interest rate higher than what it costs them to borrow, which could cause banks that need reserves not to find them. This dilemma in execution, while interesting, is highly unlikely to cause the Fed to stop its policy. Instead, it requires the Fed to tinker with both rates.
Inverted Yield Curve a Cause or a Symptom
Some believe that an inverted yield curve causes a recession as banks become less willing to lend, as their cost of funds (short-term rates) is higher than the price they can charge on a loan.
This argument seems specious because banks dictate the rate they pay depositors and the price they charge borrowers. Plus, any inversion tends to be for only a short period.
More likely, an inverted yield curve is the bond market’s diagnosis that something is amiss in the money markets and the economy.
 Google Trends, Yield Curve. https://trends.google.com/trends/explore?q=yield%20curve&geo=US
 Cox, Jeff. “The Fed Has Taken the First Step Toward An Early Exit From its Balance Sheet Reduction.” CNBC , June 14, 2018. https://www.cnbc.com/2018/06/14/the-fed-steps-toward-an-early-exit-from-its-balance-sheet-reduction.html
 Leong, Richard. “Market Rate Rise May Thwart Fed’s Balance Sheet Plan.” Reuters, June 27, 2018. https://www.reuters.com/article/us-usa-fed-ioer-analysis/market-rate-rise-may-thwart-feds-balance-sheet-plan-idUSKBN1JN2HO
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.