Yield Curve Inverts Briefly in Thin Holiday Market

An inverted yield curve sounds like a move in gymnastics, or perhaps a variety of baseball pitch. Unfortunately, it is merely a term used by economists for a rather arcane event that happens from time to time in the world’s bond markets. It usually heralds an economic slowdown, but when America’s yield curve inverted briefly this week, it did so in thin trading conditions. The jury is still out on its significance.

In order to understand precisely why an inverted yield curve may presage an economic slowdown, one must get a handle on the usual state of play in bond markets. Governments all over the world offer bonds to fund their operations in various maturities. In plain English, they sell debt that gets paid in full plus interest in two years, five years, ten years and sometimes even 100 years. The people who buy these bonds (usually big institutions like banks and bond funds) typically want higher rates of interest for longer maturities than shorter ones. This is merely common sense; more bad stuff can happen in 10 years than 2 years, meaning it is less likely for a debtor to have a problem paying off a 2-year debt than a 10-year debt.

When one charts this interest rate on graph paper over time, one gets the yield curve. The line for the shorter-term debt is at the bottom, the longer-term to the top. An inversion happens when the lines cross, and for a time the shorter term debt is more expensive to the borrower than long term. This is common sense stood on its head, or so it seems.

This inversion of normality means the bond markets expect it to be harder to get higher yield payments months or years from now than it is right now. The explanation is an expected economic slowdown. In other words, paying 10% may be easy now, but a year from now 5% could be pushing things.

On Tuesday, the US 10-year Treasury yield dipped below the 2-year, technically an inversion. However, markets need lots of actors to get precise results (and even then, markets can be spectacularly wrong), and the week between Christmas and New Year’s Day is always thin. The 2-year yield has been higher than the 3-year and 5-year Treasuries for a couple of weeks now, so there may be reason to believe a slowdown is coming. If the 10-year yield spends much time in January below the 2-year, then it’s a much clearer picture. Then, as Alan Greenspan rides off into whatever sunset central bankers get, the Fed can announce an end to the raising of interest rates while the alarmists can shriek about the "inevitable" recession.


© Copyright 2005 by The Kensington Review, J. Myhre, Editor. No part of this publication may be reproduced without written consent.
Produced using Fedora Linux.

Home