January 20, 2006

Inverted Yield Curves in the U.S.  A yield curve is a graphical representation of the yields on bonds (usually government bonds) of different maturities at one point in time.  The yield curve is, generally, upward sloping.  That is, generally, long term bonds have higher yields than do short term bonds.  Every once and awhile the yield curve becomes “inverted” or short term yields become higher than long term yields.

An inverted yield curve is often a fearful sign.  In 1960, 1969, 1973, 1980, 1981, 1990 and most recently 2001 when the yield curve became inverted a recession has followed!  Only once in the last 40 years (1966) has an inverted yield curve NOT preceded a recession.  The general reason why this occurs is that the Fed in order to slow a steamy economy and thus control inflation, increases short term rates and triggers a recession.

The yield curve today certainly appears headed toward inversion!  As the Fed continues to raise short term rates, long term rates have not increased much at all, thus giving rise to a very real possibility that short term rates, across the board, will be higher than long term rates…thus the dreaded inversion.

So is the United States headed for a recession?

Well…in depends…but probably not.  Yes, the Fed has increased short term interest rates 13 times and might continue to do so throughout 2006.  But…one has to wonder, why have long term rates not moved upward with the short term rates?  Even Chairman (or soon to be Saint) Greenspan has described these long term rates as a “conundrum.” 

Let’s look at some of the potential explanations as to why long term yields are not change very much, if face of rising short term rates:

•  Inflation worries in the future.  Maybe, just maybe the Fed is doing its job correctly.  By tweaking short term rates the Fed is tapping the breaks on money supply growth just enough to keep inflation under control.  Thus inflation in the future will be relatively mild.  Since one way to explain long term rates is that they reflect market expectations about short term rates in the future, if market participants believe inflation will be lower in the future than what it is today, longer term rates will be lower than the short term rates today.  Ideally, the inflation will remain constant and the yield curve will be essentially flat.

•  Foreigners buying long term U.S. government bonds.  Since the U.S. is running a large current account deficit foreigners are buying U.S. financial assets, or the causation might run in the other way, either way foreigners are buying U.S. bonds.  As the foreigners are bidding up the price of long term government bonds they are pushing the yields of these bonds downward.  If this is the explanation, the question is:  how long will this last?  How long will the Japanese and the Europeans keep buying U.S. government bonds in mass quantities?  The answer is:  as long as their own domestic economies remain weak.

•  Americans buying long term government bonds because their other options suck.  This argue states that the U.S. markets are weak and getting weaker.  Since U.S. households are strapped with so much debt, housing prices are softening, and bankruptcy more difficult, the U.S. consumer’s spending spree of the last few decades is coming to end.  Thus, this argument goes, U.S. firms, especially those selling to consumers are gong to have a rough time of it in the future.  Thus, these firms seeing the handwriting on the wall are buying government bonds because their own capital spending options are very limited.

So whom do you believe?

For what it’s worth, I place my bet on the first two.  I think the bond market has a great deal of confidence in a Bernanke-headed Fed.  Bernanke’s defacto inflation targeting will result in U.S. inflation remaining mild even as the second IT wave pushes the U.S. economy to grow more rapidly.

Because of this low-inflation, tech driven growth, foreigners will continue to bring their savings to the U.S.  While this may be good news for the U.S. it is not overwhelming good news for entrepreneurs in Latin America, Eastern Europe and other capital needy emerging markets.  But then again…maybe more U.S. capital, especially private equity funds, will start to flow to these markets.

All of this is NOT to say America does not have to worry about its overall lack of savings…more about that later.

All the best,