Zeev's Turnips Patch-No Politics (ZEEV)

[Gizmo]

Commentary: An inverted yield curve's all but inevitable

By Dr. Irwin Kellner, MarketWatch
Last Update: 7:03 AM ET Nov. 22, 2005


HEMPSTEAD, N.Y. (MarketWatch) -- Examining the shape of the yield curve today can tell us a lot about the shape of things tomorrow.

Any day now -- maybe even while you're reading this -- the yield curve will invert. Interest rates on the Treasury's two-year note will go above rates available on the benchmark 10-year issue.

This development can't be too far away. At last check, only six basis points (that is, six one-hundredths of a percentage point) separated the two from the ten. That's the narrowest spread since early 2001 -- just before the U.S. economy tumbled into its 10th postwar recession.

Normally, about three-quarters of a percentage point (74 basis points, to be exact) separates these two maturities. Two years ago, at its peak, this spread was a whopping 2.5 percentage points.

The yield curve could remain flat for a while, but it won't do so for long.

The Federal Reserve is widely expected to hike its federal funds rate, currently at 4.0%, by another quarter of a point when the policy-setting Federal Open Market Committee meets on Dec. 13, and a similarly sized increase is anticipated at the end of January. See our Economic Forecast page.

Unless the bond markets push rates on the long end up by at least 50 basis points over these next two months, the curve will invert. For long rates to jump this much, the rate of inflation excluding food and energy would suddenly have to surge, and/or foreigners would have to stop putting money into bonds and actually begin repatriating some of their current sizable investments.

In the absence of such developments, the curve will invert, sending out a number of messages -- each worth paying attention to.

First and foremost, by keeping long yields below short-term rates, the bond markets will be signaling that the Fed's tight money policy is choking off economic activity and that a recession is nigh.

In the past, every time short rates have gone above long yields, the economy has found itself in a recession. By the same token, every postwar recession has been preceded by an inverted yield curve.

Figuring out why this happens isn't rocket science.

When banks have to pay more for deposits (which key off short-term rates) than they can make lending these funds (which are based on longer rates), they tend to reduce this activity. In turn, this shrinks the money supply, thus starving the economy for liquidity.

Jeopardy for housing market

A recession brings with it good news and bad news.

On the good side, the decline in spending that constitutes a recession tends to keep inflation at bay by reducing demand for goods and services compared with supplies. Provided that the dollar doesn't rise in response to these higher short rates, a recession can also shrink our trade deficit by cutting our demand for imported goods.

The bad side, of course, is a loss of jobs and incomes, declining sales and profits, and a slumping stock market. Needless to say, the federal budget would be affected as well, as tax revenues decline while spending on social welfare programs rises.

Housing in particular would take it on the chin, since it requires lots of low-cost funds.

Come to think of it, this could very well be what the Fed wants. After all, outgoing Fed chief Alan Greenspan has been warning about froth in the housing market for some time, now.

http://www.marketwatch.com/news/story.asp?dist=ArchiveSplash,%20¶m=archive&siteid=mktw&a...