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Fri Jan 6 09:04:38 PST 2006

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THE LONG AND THE SHORT OF IT
Jan 5th 2006  

America's bond market is upside down. Is the economy about to capsize
as well?

SHORTLY before America's last recession, which began in March 2001,
something odd happened to interest rates. Short-term rates rose above
long. The same thing happened before the recessions of 1990, 1981,
1980, 1973, 1969 and 1960. A dark omen, then, but why worry about it
now? In recent months, yields on short-term securities have crept up on
those offered by longer-dated instruments. In the last week of
December, it was (slightly) cheaper for the American government to
borrow for ten years than for two.

 This is unusual. The government borrows by selling a variety of IOUs,
which promise to give the buyer his money back sooner (three-month
bills, for example) or later (eg, ten-year Treasuries). Normally, the
longer the maturity, the higher the yield a security must offer: the
"yield curve" slopes upwards. Markets take this to be the natural state
of affairs (though just why it should be so has taxed some of the best
economists).

When things are upended, the yield curve is said to be "inverted", a
condition now exciting much chatter among analysts. Despite all this
talk, the yield curve is not yet inverted across its full length. The
yield on two-year Treasuries may have risen above that on ten-year
bonds, but the rate on three-month bills still falls short by about 0.4
percentage points. The spread between ten-year and three-month
securities has been this narrow twice before (in 1998 and 1995) without
a recession ensuing. Nonetheless, the ironing-out of the yield curve is
not normally welcome news. According to a statistical model estimated
by Arturo Estrella*[1], an economist at the Federal Reserve Bank of New
York, a spread of 0.4 points, averaged over a month, has historically
signalled an 18% chance of recession within a year. 

What gives the yield curve its predictive power? Long-term rates
represent, in part, the market's expectations for future short-term
rates. To see why, consider an investor who wants to lend for ten
years. He could sink his money into a ten-year bond for the duration of
its life. Alternatively, he could buy a five-year bond today, rolling
his money over into another in five years' time. Suppose the five-year
rate is 5% now, but the investor expects it to rise to 10% in five
years' time. In that case, ten-year bonds must offer a yield of about
7.5% today to attract his money. On the other hand, if the investor
expects five-year rates to fall to just 3% in five years' time, he will
accept a ten-year yield of only about 4% today. In this case, long
rates will fall below short now, in anticipation of even lower short
rates later. 

An inverted yield curve, then, suggests that short-term rates are
higher today than they will be in the future. But why should this
necessarily spell recession? Normally, it is because the Federal
Reserve is in the midst of a campaign against inflation. To win this
battle, short-term rates are sometimes raised high enough to induce a
recession, which squeezes inflation out of the system. In due course,
lower inflation will pave the way for lower short-term rates. But
before this happens, long-term bond yields fall in anticipation of the
future victory. In this case, an inverted yield curve is just a measure
of the Fed's power.

Alternatively, inversions may be a measure of the Fed's ignorance. The
bond market may know something the central bankers don't. Long-term
rates may be subdued, because the market anticipates a recession that
will eventually force the Fed to loosen monetary policy. But short-term
rates remain high, because the Fed has yet to act on what the bond
market foresees.

A PORTENT AND A PUZZLE
So does the flatness in today's yield curve mean that the Fed is trying
to engineer a recession? Hardly. The Fed's rate-setting committee no
longer describes its monetary stance as "accommodative", but neither is
it trying to cage a runaway economy. At 4.25%, its key rate is still
much lower than the rate of growth in nominal GDP (more than 7%,
annualised, in the third quarter), which serves as one crude measure of
policy's tightness. According to the minutes of its December meeting,
released this week, some members of the committee reckon that the
federal funds rate is probably within a neutral range, one that should
allow the economy to grow at close to its full potential.

In contrast to previous inversions, the yield curve is flat not because
short rates are unusually high, but because long rates are unusually
low. Yields on ten-year Treasuries have hovered around 4-4.5%, even as
the Fed has hoisted short-term rates 13 times. Alan Greenspan, the
Fed's chairman, himself does not fully understand why this is so--no
doubt it has much to do with foreign purchases of long-dated American
securities by oil producers and Asian central banks. Nonetheless, on
this reading, the bond market offers a puzzling "conundrum", as Mr
Greenspan has put it, not a worrying omen. Optimists find comforting
parallels in the events of 1966. In the last few months of that year,
the interest rate on three-month bills edged above that on ten-year
bonds, but no recession followed--the only time a fully inverted yield
curve has cried wolf. Then, as now, long-term rates were unusually low,
averaging under 5%.

The pessimists, however, look back five years, not 40. In the second
half of 2000 the yield curve inverted, and then, as now, the vast
majority of commentators dismissed it, arguing that the old portent had
nothing to say about the new economy. Three months into 2001, the
economy slipped into recession.

Although monetary policy may not be that tight as yet, the economy's
strength may rely, more than most realise, on interest rates remaining
low. To a disturbing degree, America's economy is still debt-led. Can
this borrowing continue to drive growth now that interest rates are no
longer "accommodative" and house prices are starting to cool? The
answer is not easy to find in the bond market. But it will decide
whether America's economy is as flat in the year ahead as the yield
curve is today.

* "The Yield Curve as a Leading Indicator: Frequently Asked Questions".
October 2005. Available at
www.newyorkfed.org/research/capital_markets/ycfaq.pdf[2]

-----
[1] http://www.economist.com/#footnote1

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