In the monetary scenario, increasing inversion suggests current problems are worse than most people think, and the Fed has the ability and willingness to solve them. In the real economy scenario, it suggests the problems are in the future, and political leaders have the ability and willingness to create them.
So, is our current inversion primarily monetary or real? One clue is how much the Fed has raised rates. In the 1978 – 1980 inversion, the average federal funds rate during the time of inversion was 194 basis point higher than the average of the previous two years. But in the next four inversions, the average during the period of inversion was substantially lower than average rate from the prior two years. This suggests that the 1978 – 1980 inversion was monetary, while the next four inversions were economic.
In the 2005 – 2007 inversion, the average fed funds rate was 122 basis points higher than the average of the prior two years, and in the current inversion it has so far been 124 basis points higher. This suggests these last two inversions are monetary, but not (yet) as extreme as the Volcker Shock.
But if the inversion reflects investor predictions of the future, we should see it in the real return of the S&P 500 Index during the period of inversion. So far stocks have lost 14% to inflation over the current inversion. The only other inversion with a negative S&P 500 real return was the 1980 – 1982 inversion, with a real loss of 18%. This suggests that those two inversions were real. So, the current inversion has strong monetary and real components.
Before over-reacting and predicting disaster, remember that the current inversion is only 77 basis points, compared with the 241-basis-point peak in 1978 – 1980 and 170 basis points in 1980 – 1982. Plus, Fed rate increases of 124 basis points are well below the 194 basis points of 1978 – 1980, and the stock market decline of 14% is not as severe as the 18% of 1980 – 1982. So, while the signs are ominous, they’re not yet at a level to expect Volcker Shock conditions. We will likely have a recession, and it may be more painful than the previous four, but as of now it seems likely to be more similar to those last four than to the disruption that ended the 1970s inflation express.
This article was provided by Bloomberg News.