Federal Reserve Chairman Ben Bernanke made a clear bet last week that pushing short-term interest rates above long-term rates won't send the economy into a recession -- or stop the central bank from raising rates.
On Friday, the bond market called that bet. Long-term Treasuries rallied, with the 10-year yield falling to 4.54% and the 30-year yield down to 4.51%. Meanwhile, the three-month yield ended at 4.55% and the two-year at 4.68%.
The day's moves ups the stakes for Fed policy-makers planning to raise rates in the coming months.
The latest inflation readings muddied the picture further. Core producer prices, which exclude food and energy, rose 0.4% in January, the biggest gain in a year, the Labor Department said Friday.
But year-over-year, core prices rose just 1.5%, the lowest since August 2004. Also, energy and other commodity prices have retreated in February, so that makes Jan.'s PPI report look out of date.
What is clear is that bond investors are willing to lock in money long-term at a lower rate than short-term options, a sign they don't expect strong future growth.
That's not how Bernanke sees it.
Testifying Wednesday before the House Committee on Financial Services, he called the economy "on track" and stated unequivocally that an inverted yield curve isn't worrying the Fed.
"Historically, there has been some association between inversion of the yield curve and subsequent slowing of the economy. However, at this point in time, the inverted yield curve is not signaling a slowdown," he said.
The University of Michigan said Friday that its February consumer sentiment index fell 3.8 points to 87.4. But overall the latest data have been strong, from retail sales to housing starts to factory activity.
Still, many bond watchers, betting on the side of history, disagree with Bernanke.
"Every recession has been accompanied by an inverted yield curve. It does portend an economic slowdown. For the Fed to say this time is different, it's a little confusing," said John Norris, chief economist with Morgan Asset Management.
Past inversions almost always foreshadow a slowdown and often a recession. This time might be different, but an extended, deepening inversion would be troubling.
"(F)or the engine to keep humming along, you need the ability to borrow low and lend high," said Steve Rodosky, a senior vice president and portfolio manager at PIMCO. "Profits accelerate when yield curves steepen and vice versa. We don't understand how everybody can discount that truth."
Bernanke argues there's been a structural shift in the bond market.
Cash-rich foreign investors as well as U.S. pensions and insurance companies are willing to accept low long-term yields in exchange for the safety of U.S. assets, he said.
He also notes that inversions ahead of past recessions came at a time when overall rates were much higher than they are today.
Those low long-term yields make it harder for the Fed to keep the economy from overheating, thus forcing policymakers to raise short-term rates higher.
Fed funds futures have priced in a 15th straight quarter-point rate hike on March 28, with another increase likely by midyear, to 5%.
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