Should Rochester fear the ‘inverted yield curve’?

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The yield curve compares interest rates charged on long-term and short-term bonds—typically, 10-year vs. two-year U.S. government treasuries, or U.S. Treasury debt. When the 10-year rate is lower than the two-year rate, the yield curve is said to be “inverted” and may be “predicting” a recession.

Let’s unpack the yield curve. Forget the almost “magical” significance ascribed to this number. The yield curve is just a sophisticated investor confidence survey. The point of “inversion”—where the short rate rises above the long rate—is inconsequential by itself. Take a look at the chart: These two rates have been converging for more than a year as market conditions have changed. In purely financial terms, the long rate falls and the short rate rises if investors expect inflation to be lower in the future.

Some of you may remember the TV series, “Early Edition.” Every morning the protagonist found tomorrow’s newspaper outside his door. Blessed (or cursed) by knowledge of the future, he spent the rest of the episode trying to fix things.

Suppose you found the Wall Street Journal from 2028 on your doorstep or in your email’s inbox and learned that inflation, 2.5 percent today, had risen steadily to 5 percent. To compensate for the loss in inflation-adjusted yield (the interest rate minus inflation), you would demand a higher interest rate for bonds with longer maturities: The 10-year rate minus the two-year rate (the yield curve) would go up.

On the flip side, if your “early edition” of the WSJ showed inflation to have stayed the same or fallen, you’d be willing to accept a lower long-term yield (rate of interest).

The key to interpreting the yield curve is this: Inflation is usually associated with a thriving economy. If bond traders accept a lower interest rate for longer maturities than for shorter maturities (that’s the inverted yield curve), then they must be expecting the economy to slow down. And vice versa. Bond traders express their opinions with their dollars.

They are not always right. Bond traders are just as subject to “group think” as anyone else. Still, a flat or inverted yield curve has a real impact on banks as they are in the business of borrowing at low current rates and lending at higher long rates. They lend less when they are worried about the future stability of the economy. The yield curve “crowdsources” the expectations of investors.

Expectations can be contagious, too. Fear of recession can spur a reduction in investment and risk taking, and make a recession more likely. That’s why words matter. When President Trump starts a trade war—which most investors believe will slow the economy, at least in the near term—then those fears will increase demand for short-term securities and reduce demand for long-term securities.

How does this apply to the Rochester-Finger Lakes?

National economic trends do not affect all regions alike. When Rochester’s economy was intimately tied to Kodak, it was insulated from many of the ups and downs affecting the nation. Kodak’s principal product, photographic film, was a consumer staple. When the economy slowed, vacations might be scaled back—a distant destination might be replaced with a more modest trip. Parties might be less grand. But pictures were still part of our culture. And Kodak’s consistent profitability made the cycles of hiring and firing that were common to more cyclical or competitive businesses unnecessary.

Today, Rochester’s economy counts as one of the most diversified. The economic analysis firm EMSI recently ranked the nation’s metros on the underlying diversity of employment and Rochester ranked No. 5. This is in sharp contrast to the days when the “Big Three” (Kodak joined by Xerox and Bausch & Lomb) drove most economic activity. A similar study from the 1980s ranked Rochester as the least diversified large economy in the nation.

So the insulation from external events is largely gone. Just like the rest of the economy, Rochester needs to pay attention to national indicators. That said, neither a falling yield curve nor an inversion is destiny. Many indicators suggest that the national economy is doing just fine and that growth will continue apace. And yet…

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