Tuesday, February 28, 2006

Inverted Yield Curve: Special this time?

As many of you know, the yield curve (a graph showing the yield of treasury securities against their maturity) has inverted. This means that long term rates are now lower than short term rates. This is widely recognized as one indicator of a future downturn in the economy, also called a recession.

I was struck by the Jan 31st testimony of Alan Greenspan, who seemed to think that the yield curve won't be predictive of a recession due to special circumstances this time. How many times do we have to learn that special circumstances are rarely all that special when it comes to economics. It reminds me of the talk of the "new economy" in 1999; how the business cycle was dead and all that. Turned out the miracle economy was a bubble, and the correction came as many predicted.

An inverted yield curve can only mean that the bond market thinks inflation will be lower long term than it is now. As we know from the expectations theory of interest rates, yields are a sum of the numerous expectations of investors. When the long rate is lower than the short rate, investors sense something is about to change; that inflation is going to fall. Inflation falls when business activity is reduced, meaning that the economic growth declines or goes negative outright.

On the plus side, long rates being as low as they are is a good signal for the dollar, IMO. I don't see any evidence of the feared capital flight, which would drive rates, particularly long rates way up. That will be little comfort when the prediction of the yield curve comes to pass --- recession in the next 12 to 18 months (end of 2007).