Reading Han Sang-chun’s International Economy: Long- and short-term interest rates inverted in the US… How will it affect the stock market?

After the recent Federal Open Market Committee (FOMC) meeting of the US central bank (Fed), the yield curve inversion, that is, the inversion between long-term and short-term interest rates, has sparked controversy over the direction of the US economy. Interest rates on 5-year and 10-year bonds and between 3-year and 10-year bonds have already inverted. What remains now is when the yields on the 2-year, 10-year, 3-month and 10-year bonds will reverse.

According to the ‘liquidity premium hypothesis’, ‘expectation hypothesis’ and ‘split market hypothesis’, if the yield curve shows a positive (+) slope, the economy will recover, and if it shows a negative (-) slope, it has been interpreted as a recession. From 1960 to before the global financial crisis, the yield curve inverted 15 times, accompanied by economic recessions without exception.

However, after the financial crisis, the relationship between the yield curve and the economy began to deteriorate. Fed Chairman Jerome Powell and Treasury Secretary Janet Yellen said the recent yield curve inversion was unacceptable as a recession. On the other hand, American academics, such as Harvard University professor Larry Summers, analyzed it as a foreshadowing of a structural long-term recession.

The biggest reason that the relationship between the yield curve and the economy has become more erratic after the COVID-19 crisis is that the Fed’s monetary policy jurisdiction has changed from the ‘Greenspan Doctrine’ to the ‘Bernanke Doctrine’ after the financial crisis. Former Fed Chairman Ben Bernanke argued that monetary policy should be managed in consideration of conditions in the real economy and the asset market in the former, while the latter in consideration of conditions in the real economy as well as asset market conditions.

For the relationship between the yield curve and the economy to fit well, finance must properly reflect the conditions of the real economy. However, after the financial crisis, as the Fed implemented monetary policy in consideration of asset market conditions, the size of finance has more than tripled compared to the real thing, and the causal relationship has also changed to a position where finance leads the real world rather than following it. .

What is important is whether we can completely ignore the usefulness of the yield curve as an economic forecasting indicator. In order to understand this point, the Fed also provided its own service to Arturo Estrella (Rensel Polytechnic University) and Professor Frederick Mishkin (Columbia University) and his team, showing that the yield curve spread is still more useful than any other indicator.

In particular, the ‘level’ of the yield curve spread was evaluated to have better predictive power than the ‘change’. It is also known that ‘investment guru’ such as Warren Buffett and George Soros use the economic forecasting power of the yield curve spread announced every month by the Federal Bank of New York using a probabilistic model when making investment decisions.

A probabilistic model is a model that converts the probability of a recession within 12 months into a probability using the cumulative probability distribution of the yield curve spread. As a result of estimation by this model, the probability of predicting a recession by inversion of the yield curve spread has risen to 98% during the 1981-1982 recession. However, after the financial crisis, that probability has frequently been witnessed.

Regarding the recent inversion of the yield curve, the debate among world-renowned scholars as to whether “it heralds a full-scale recession” or “no” is a valid argument. One thing is clear: the inversion of the yield curve was previously driven by a fall in long-term interest rates, but recently, short-term interest rates, which reflect policy factors, have risen faster.

Contrary to market expectations, Fed officials, who had been criticized for raising interest rates by only 0.25 percentage points, were criticized for ‘regressive selection theory’, have been pouring out more aggressive interest rate hikes after the March meeting. According to the dot chart in March, where you can read the intentions of Fed officials to change interest rates, it is expected to raise the key interest rate six times in the remainder of this year and up to four times next year.

The yield curve inverted after the Fed meeting in March, which is why the US stock market is holding up better than before. Rather, various carry funds aimed at interest rate gains and foreign exchange gains are directed to the US. It is time for Korean policy makers and stock investors to carefully read and respond to the new normal phenomenon, which does not apply to previous theories and norms as well as the relationship between the yield curve and the economy.