One of my favorite national economists Brian Wesbury last week wrote about the fears around a Yield Curve Inversion which many “experts” and economists believe accurately predicts when the next recession is about to happen. Here in the middle of July the yield spread between the 2 year and 10 year Treasury Note has narrowed to just 25 basis points, its smallest spread since 2007, right before the last recession. This is causing “experts” to say a recession is coming soon.

However, Brian points out, “In reality, an inverted yield curve simply means long-term investors expect short-term rates to fall in the future.” Brian also says, “An inverted yield curve does not CAUSE a recession.” Instead, it’s tight monetary policy by the Fed that causes recessions. Brian says, “the inversion is a symptom of the bigger issue. Investors, realizing the Fed is too tight, push long-term rates down because they expect the Fed to reduce short-term rates in the future.” In other words the market of long-term investors moves faster and earlier than the Fed does.

Later in his article he brings up the idea that the “10 year Treasury is overvalued—possibly in a bubble.” That is a SHOT ACROSS THE BOW I believe and it will be interesting to see if other people agree with Brian. Personally, I think Brian is correct.

Brian finalizes his case by saying, “Nominal GDP growth is a good proxy for a ‘natural or neutral’ rate of interest because it’s the average rate of growth in the economy. What is nominal GDP? It’s real growth plus inflation in a nutshell and Brian says that for the last 20 years 10 year Note yield has averaged just 0.43% lower than nominal GDP growth. Where is at now?

Currently, the 10 year Note yield at 2.83% is a whopping 187 basis points below the nominal rate of GDP growth (4.70%). Thus, at this rate of GDP growth he believes the 10 year Note yield should be roughly 4.25%, which would put mortgage rates at 6%. WOW! Thus, the Fed policy is nowhere near tight as the Fed should raise short-term rates by another 1.50% according to Brian.

Now I don’t know that Nominal GDP is a good proxy for where a neutral short-term interest rate is as I am not that much of an economics geek. But, I understand Brian’s rationale and he may be right about the 10 year Treasury Note being in bubble territory. If he is right than mortgage rates can rise much more.

On this topic last Wednesday Ben Bernanke said that an inverted yield curve may not signal a recession. Why? Quantitative Easing that Mr. Bernanke implemented has so skewed the world’s economies. He also said don’t expect the Fed’s balance sheet to shrink under $1 trillion like it was before 2008. He said the normal level may be $3 trillion; still the Fed’s balance sheet is over $4 trillion currently.