Innovation and the yield curve

The inverted yield curve signals a recession – or does it?

For equity investors trying to time the next big crash, there is nothing better than the yield curve. Ever since Campbell Harvey, professor of finance at the Fuqua School of Business at Duke University, spotted it´s power to predict recessions and associated market routs, the difference between short term and long term bond yields more and more investors joined the crowd to monitor it. And that´s perfectly understandable as an inverted yield curve (long dating bonds offering lower yields than short term bonds) proofed to be one of the best recession indicators in recent decades:

I don´t want to go into the debate, which yield curve is the right one to watch (3 months/10 years, 2 years/10 years, etc). And luckily, we don´t have to, because nearly all versions flash as a recession signal these days with curves in the US inverted for several weeks. Also, I don´t want to get into the details of Quantitative Easing and how it might have impacted the curves prediction power. And finally, also, I don´t want to write about the very small amount of data points that the inversions present – letting data scientists shiver at the idea of betting on it.

Bad Deflation

Instead I want to argue about the reasons, why a curve inversion works as a signal and why it might not so in the current situation. There are two ways of reasoning behind the curve inversion, that somehow intertwine:

  1. As investors expect lower growth/a recession/risks for risky assets to rise, they pile their money into the safest asset there is: 10-year treasury bonds. That demand for safety pushes the yield for those bonds below short-term paper.
  2. As investors expect very low inflation or even deflation, the higher inflationary risks of long-term bonds are reduced, making long term bonds more attractive

I must admit, I do have problems with the first one (why are 10-year treasuries safer than 3 month-bills?). But let´s focus on the second one. That´s because using this argument assumes that lower inflation always signals something bad in terms of growth prospects, incomes, economic wellbeing, etc. And I like to doubt that.

Yes, deflation caused by a big lack of demand like in the great depression, surely is something to worry about. It can aggravate things in a downturn (deflationary downward spiral anyone?). But deflation is not a bad thing in itself (if your balanced sheet is not stretched too much). It is after all the goal of market based, capitalist systems to bring down prices for goods and services and by that increasing purchasing power. Why after all would we be praising competition if it weren´t to serve customers with cheaper prices. What would be all this innovation about, if not for the goal to offer the same at a cheaper price or something better for the same price?

The fact that innovation – the quest to solve a problem with higher efficiency – is deflationary seems to have gone lost in the discussion in the ivory towers of academic institutions. Just ask people on the street, what they would like chose: more expensive products or cheaper, better ones?

Good Deflation

Taking up from here, I want to point to an article from Catherine Wood (here), founder and CEO of ARK Invest, an asset manager focusing on innovative companies (like we do with our fund). She dug a little bit deeper into the history of inverted yields and found something interesting: Before the crash of 1929, followed by the great depression, inverted yield curves were very common and did not signal recessions at all:

Wood writes: “Roughly 150 years ago, the three innovation platforms that changed the way the world worked were the internal combustion engine, telephone, and electricity. During the 50 years ended 1929, unit growth and productivity surprised on the high side of expectations as inflation surprised on the low side, creating a “deflationary boom” and an inverted yield curve “.

And she adds: “For the first time in 100 years, we believe that innovation is picking up at a pace not seen since the turn of the nineteenth century, causing a confluence of abnormal economic signals that are stirring fear, uncertainty, and doubt. In our view, however, these signals could be harbingers of boom times ahead.”

One must be careful to draw too strong parallels with economic history and data from 150 years ago. The FED for example was only founded in 1913 and modern rate policy and inflation goals were not existent in the period Wood describes. But I do think, it´s worth to hear Wood´s arguments.

We do live in extraordinary times of technological change, no doubt about that. And if that golden age of innovation works as in the past, we should see deflationary pressure. Just think about the way the internet increased price transparency and put a lid on overcharging for comparable products. Maybe I am too much of an optimist. But I can follow Catherine Woods arguments for “good” deflation, and they seem at least not worse than staring at one signal and sell without asking questions.

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