The inverted yield curve: Does it really presage a US recession?

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The Independent Online

There was a sudden flurry of interest this week in the otherwise moribund post-Christmas financial markets. The source? A rare phenomenon known as the "inversion of the yield curve".

While most investors, traders and analysts were taking advantage of the short trading week between Christmas and new year, the yield on the 10-year US bond sank below that of the two-year instrument. This happens very rarely and when it does, it has historically presaged a recession.

Long-term bonds tend to attract higher rates to offset the risk of inflation further out. It didn't last long - a few hours on Tuesday - but it managed to trigger a 100-point fall on the Dow Jones blue-chip index.

Each of the six recessions in the US since 1970 was predicted by an inversion in the yield curve - although crucially an incidence of the phenomenon in 1998 did not.

But is a recession really likely or is there another explanation? Economists keep saying we have entered a new paradigm of robust growth with low inflation and interest rates, so perhaps this once-popular indicator is now defunct. Certainly Alan Greenspan, the outgoing chairman of the US central bank and a man with five decades of experience in the capital markets, believes it has.

He told Congress during his annual testimony in November: "This used to be one of the most accurate measures we used to have to indicate when a recession was about to occur. It has lost its capability of doing so in recent years."

He followed this up this month in a letter to a Republican Congressman, Jim Saxton of New Jersey, saying a "flattening of the yield curve is a not a foolproof indicator of future weakness". He pointed to an instance in the early 1990s, just before the US entered a period of unbridled expansion.

A recession does not seem to be on the cards on Wall Street. Finance houses expect the US Federal Reserve to continue with its programme of monetary policy tightening of monetary policy that has see rates rise by 325 basis points from 1 per cent to 4.25 per cent over the last couple of years.

Median forecasts show US rates peaking at 4.75 per cent in the second quarter although most economists expect GDP growth to slow to 3 per cent in 2006 from this year's solid level of 4.1 per cent.

But some people are worried. The last time the yield curve inverted, in the second half of 2000, it was seen as a sign of an economic slowdown. Lo and behold, the US went into recession in spring 2001 and interest rates started to tumble.

Simply put, the yield inverts when the Fed takes aggressive action to curb inflation, driving up short term rates, allowing investors worried about a major downturn further out to make their feelings shown by buying longer-term bonds.

Hugh Johnson, the chairman of Johnson Illington Advisors in the US, told CNN: "The biggest risk in 2006 is that the Fed will be seduced by worries about inflation into raising rates too high. A lot depends on what the 10-year does and while I hope they would take notice that it's going down in yield, the question is whether they take it seriously or dismiss it."

Most analysts see the inversion as a "flashing yellow light" against a background of resilient economic growth, strong retail sales and mild inflation.

Alan Ruskin, the research director of analysis firm 4CAST in New York, said it was a sign that the economy was heading for slower growth rather than recession. "I would be a lot more worried if the two-year yield had gone up 100 basis points and the 10-year by 90. Instead what we have is the curve inverting while yields are going down," he said.

"As long as yields remain at these low levels then we can be more confident about a soft landing."

This has caused analysts to search for other explanations. It can be caused by technical factors such as a flight to quality or global economic or currency situations that trigger demand for long-term bonds.

When Long Term Capital Management, the US hedge fund, failed, the yield inverted as demand for safe 10-year T-bonds surged.

This year the yield on long-term bonds has flattened as central banks in Asia have embarked on a major buying spree, raising the price and depressing the yield. At the same time, strong economic growth in the US has supported short-term yields.

Mr Ruskin said the market was probably distorted by the thin level of trading and the need for traders to liquidate positions at the end of the calendar year.

But he said it also related to the issue of a low long-term bond yield at a time when the prognosis for the US economy was positive. Mr Greenspan referred to this in his February Congressional testimony as a "conundrum" in world bond markets that he said he might be a short-term "aberration".

One possible explanation has come from Mr Greenspan's successor at the helm of the Fed, Ben Bernanke. Mr Bernanke has raised the idea of a "global savings glut" a supply of saving significantly higher than investment demand in Asia and other parts of the world.

Stephen Lewis, the chief economist at Monument Securities, said it was possible that the inversion had nothing to do with investors' expectations of future inflation. "It may reflect, rather, shifts in the structure of the flow of funds," he said.

"If this is the case it will be fruitless to look for a link between the yield curve and economic indicators. The inversion will persist as long as the shifts in flows are sustained."

Or as Mr Greenspan put it in his letter to Mr Saxton: "Many factors can affect the slope of the yield curve, and these factors do not all have the same implications for future output growth.

"In judging the indicator value of any particular change in the slope of the yield curve, it is critical to understand the underlying forces that may be affecting the yield curve at the moment."