Leading Indicator of a Recession or Profitable Opportunity?
The week after Christmas is typically a slow one where many Wall Street traders stay at home enjoying an extended Christmas holiday. Early predictions of it being a slow week on Wall Street were jolted this morning when for a few brief moments the yield between the U.S. two and ten years notes inverted. An inverted yield curve usually is a leading indicator of an economic recession. In fact every time in recent memory that the yield curve has inverted a recession has followed. The inverted yield curve, along with the lack of buyers, lead to a strong sell-off in stocks today. Financial Watch believes the sell-off reflects negative sentiment presently in the market. The U.S. economy seems poised to turn in another decent year next year and any concerns about a recession are overblown. Alan Greenspan dismissed concerns over an inverted yield curve several weeks back and we believe today’s inversion will not impact his decision to raise interest rates another quarter point at January’s meeting.
While Financial Watch believes concerns over an inverted yield curve were overblown, we do recognize its importance of an upward slopping yield curve to banks. Commercial banks have been dealing with a flat yield curve for most of the past year and should only be slightly impacted if short end yields more than the long end for a prolong period. A more dramatic impact should occur for the Investment Banks. Every bond trader worth his salary should have rushed back to the office once learning of the inverted yield curve. The current inversion between the U.S. two year (4.29% yield) and U.S. five year (4.34% yield) notes represents a rare arbitrage opportunity for the Investment Banks. Bond traders have an opportunity to profit without taking on any risks. What makes this opportunity even more remote is the fact the Federal Reserve in likelihood will raise interest rates at their next meeting. Either the bond markets know something everyone else does not or U.S. securities are seriously mispriced. Investment Banks such as Goldman Sachs, Lehman Brothers, Bear Stearnes, and others should have seen their share prices move up on this rare arbitrage opportunity.