Below is an extract from a commentary originally posted at www.speculative-investor.com on 27th August 2006.

What does an inverted yield curve really tell us?

It is well documented that an inversion of the yield curve (the shortest-term interest rates rising above the longest-term rates) almost always precedes a recession, and that, if history is anything to go by, once the yield curve becomes inverted there's a high probability of a recession beginning within the ensuing 12 months. With this in mind, does the US yield curve's momentary inversion in February of this year combined with its recent return to inverted territory mean that the US economy is bound to enter a recession at some point over the coming year?

We are going to answer the above question in a roundabout way because we don't think the situation is straightforward. In particular, we don't think it is reasonable to assume that a recession will follow this year's yield curve inversion, or even to conclude that this year's inversion of the yield curve means that there is now a high probability of a recession during 2007, simply because a recession has followed most previous inversions.

A prolonged and substantial contraction of the spread between long-term and short-term interest rates, such as we've seen over the past three years, will generally LEAD to a less-liquid financial environment. However, the yield-spread contraction itself is typically a response to INCREASING liquidity because it stems, in large part, from the eagerness of speculators to 'borrow short' in order to either 'lend long' or buy whatever's going up in price (the increasing speculative demand for short-term money pushes up short-term interest rates relative to longer-term rates). Think of it this way: a contraction of the yield-spread is generally associated with EXPANDING liquidity, but it leads to (paves the way for) a REDUCTION in liquidity in the same way that a bull market paves the way for the subsequent bear market. Similarly, a widening of the yield-spread will generally be associated with falling liquidity, but it will lead to (pave the way for) a more liquid financial environment in the same way that a bear market will pave the way for the ensuing bull market.

It is therefore wrong to think of a contracting yield-spread as bearish -- even if it contracts to the point where the yield curve is completely inverted -- for the same reason that it would be wrong to think of a bull market as being bearish. The higher valuations go during a bull market the greater will become the risk of the trend reversing from bullish to bearish; and the more the yield-spread contracts the greater will become the risk of its trend reversing. But just as the equity bull market that ended in 2000 blew past all previous valuation peaks it's conceivable that the yield-spread contraction that began in late 2003 will continue for much longer and become far more pronounced than most rational observers currently expect.

Further to the above, the yield-spread's recent move into negative (inverted) territory does not necessarily signal an imminent problem. In fact, as long as the yield-spread maintains its DOWNWARD trend then the trades that have worked the best over the past few years will probably continue to work well and recession forecasts will be premature. Instead, the signal that things are about to take a dramatic turn for the worse will be an UPWARD reversal in the yield-spread.

To further explain the above point we'll use the hypothetical example of a technical indicator that generates a signal whenever the S&P500 Index becomes overbought. Sometimes the S&P500 will reverse downward as soon as this technical indicator generates its signal, but at other times the index will continue to push higher for a long period after our hypothetical indicator reaches 'overbought'. Therefore, rather than automatically 'going short' as soon as the indicator generates its 'overbought' signal it will make sense for a trader to wait for some evidence of a downward reversal before betting against the stock market.

The 'overbought' signal generated by the indicator in the above example is analogous to an inversion of the yield curve. The yield curve becoming inverted is, in effect, an indication that short-term interest rates have become 'overbought' relative to long-term interest rates. And in the same way that the stock market can continue to push higher for a long time after it becomes 'overbought' there's no telling, in advance, how long short-term yields will remain 'overbought' relative to long-term yields. Therefore, rather than blindly assuming that the yield curve's inversion portends a recession within a certain timeframe it makes sense to wait for evidence that short-term interest rates have begun to trend LOWER relative to long-term rates before leaping to any conclusions regarding the timing of the next major economic downturn.

In a nutshell, the time to start worrying about a recession isn't when short-term interest rates rise far enough relative to long-term interest rates to cause the yield curve to become inverted; the time to worry is when -- sometime after an inversion has occurred -- evidence begins to emerge that short-term rates have embarked on a DOWNWARD trend relative to long-term rates.

Current Market Situation

The following chart shows the TYX/IRX ratio (the 30-year interest rate divided by the 13-week interest rate), a proxy for the US yield-spread. When this ratio moves below 1 it means that 13-week interest rates are higher than 30-year interest rates and, therefore, that the US yield curve is inverted.

TYX/IRX bottomed at the end of February (at slightly below 1) then rallied into the first half of May before dropping back to its February low. If it continues to decline from here, that is, if the yield curve now becomes increasingly inverted, then it will be reasonable to conclude that the liquidity-driven booms in stocks and commodities are intact and that it's too early to begin anticipating a recession. On the other hand, if the TYX/IRX ratio reverses upward and takes out its May high then we will have a clear sign that the intermediate-term outlooks for the broad stock market, cyclical commodities and economic growth have turned decidedly negative.

At this stage we expect that there will be an upward reversal in the yield-spread before year-end.

One important implication of a yield-spread reversal

Gold is counter-cyclical and generally fares poorly relative to cyclical commodities such as copper when liquidity is expanding (when the yield-spread and credit spreads are narrowing). For the same reason, it tends to perform well when liquidity is contracting (when the yield-spread and credit spreads are widening). It's not surprising, therefore, that there was a major upward reversal in the gold/GYX ratio (gold relative to a basket of industrial metals) during the second half of 2000 -- at around the same time that the yield-spread was bottoming. And it is also not surprising that there was a major downward reversal in gold/GYX during the second half of 2003 -- at around the same time that the yield-spread was peaking.

The following chart illustrates the relationship between the yield-spread and the gold/GYX ratio.

Further to the above, a highly probable implication of the coming upward reversal in the yield-spread will be the ushering-in of a 1-3 year period during which gold moves substantially higher relative to almost everything, particularly cyclical commodities such as copper and oil. In fact, it's quite likely that an upward reversal in gold/GYX will LEAD an upward reversal in the yield-spread.