Inversion aversion: What Wall Street is worried about

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Published: Saturday, 12 Oct 2013 | 7:00 AM ET
By: | Managing Editor, CNBC.com
Ryasick | E+ | Getty Images

There is a little dipsy-doodle occurring in the debt markets amid all the political fracas that's been going on lately. It's got the attention of serious Wall Street types. More general investors may want to pay attention, too.

Think about bonds for a minute. Typically, the longer the time period of the bond, the more interest earned. After all, if you're lending and risking the money over a longer period of time, you want a bigger return, right?

But a sudden problem, like our recent congressional shenanigans, can get folks worrying about the immediate future.

As a result the market wants higher rates for shorter duration bonds. This changes the typical curve of interest rates over time.

Instead of starting low and going high, the curve inverts, with shorter-term rates going higher than longer-term ones.

Here's the key takeaway: An inverting yield curve is known to be a signal that a recession is ahead.

So when one-month Treasury bill yields went higher than bills in the three- to six-month range (see chart), Wall Street got concerned.

"Changes in interest rates typically happen slowly but unalterably," said Michael Farr of the investment firm Farr, Miller & Washington. "When the ocean liner begins to move on a certain course, it is hard to change and usually gains momentum. Any lasting inversion in the yield curve, when short maturities yield more than longer maturities, is a very consistent indicator of recession. This blip may indeed be a blip or the first canary among many to swoon."

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The prevailing wisdom says this little dip is, well, a little dip. It wasn't due to fundamentals, like a sudden decrease in corporate revenue or a shortage of manufacturing supplies. Rather, it was psychology and politics. All the Washington fuss unnerved some Wall Street players, making them think that there was a possibility that short-term debt wouldn't pay up on time.

Amplifying that move in the debt markets, the price for insurance against a default on U.S. short term debt also rose. Indeed, it inverted there, too, with the cost of insuring one-year debt higher than the cost of insuring five-year debt.

Short-term debt is crucial to money market funds and other types of funds that most people think of as stable and conservative investments. The downside of those funds not performing to expectations is severe, so you saw outfits like Fidelity dump the debt.

(Read more: Is your money market safe?)

"They can't afford that bad publicity," said Andrew Burkly of Oppenheimer during an interview on CNBC's "Squawk on the Street".

Once the shutdown-debt ceiling-partisan stalemate ends, the thinking goes, demand for short-term debt will return.

Then again, if the political wrangling continues or the current soft economy gets softer, the blip could get bigger.

Allen Wastler is managing editor of CNBC Digital. Follow him on Twitter @AWastler. You can catch his commentary here and on CNBC Radio. And check out his fiction.

Amid all the politicking this past week, the bond market started throwing up a recession signal. The question is whether it's a blip or a true bad omen.
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