The yield curve, as measured by the ratio between the 10 and 2 year treasuries, is merely a few ticks away from inverting. This is something worth paying close attention to.
What’s the significance of an Inversion?
It reflects a decreasing demand for capital (low long rates), and can also be read as the Bond Market’s apprehension of a slowing economy — why buy short Bonds if they are about to get even cheaper?
While not every inversion leads to a recession, every recession has been preceded by an inverted yield curve. Thus, it can be described as a necessary but not sufficient factor for a subsequent recession.
According to a Dow Jones article in today’s WSJ:
"Bond analysts aren’t holding out much hope that the 10-year Treasury note will end 2005 with a bang, but the yield curve may ignite some fireworks.
The benchmark 10-year yield, which is sitting just below the 4.4%-4.6% range it had been confined to for more than a month, probably won’t stage a significant breakout during the last trading week of the year, analysts say.
But it’s a different story for the two-year note. Amid upcoming supply as well as widespread belief that the U.S. Federal Reserve will raise rates one or two more times, the two-year yield is likely to head higher. A bond’s yield rises as its price falls.
When the two-year note underperforms the 10-year issue, the difference between these notes’ yields — which slid to 0.01 percentage point last week — has the potential to disappear altogether, and the two-year note’s yield can even surpass the yield on the 10-year.
When shorter-dated yields overtake their longer-dated counterparts, the yield curve is described as inverted. It is a bond-market rarity that has historically foreshadowed recession."
The 2/10 relationship — and whether it becomes inverted — has been one of several traditional harbingers of ill economic winds. There has already been Inversion "in the shorter end of the yield curve, with two-year notes yielding about 0.04 percentage point more than five-year notes late last week."
Fed Chairman Alan Greenspan has noted that "its different this time." He has challenged the view that "inversion signals economic trouble, pointing out that the shape of the curve is less predictive than it once was."
Further, the depth and duration of the inversion also plays a hand in its predictive ability:
"While an inversion between two- and 10-year "seems in the cards," some bond managers expect the flip-flop in yields to be minimal — just 0.1 to 0.15 percentage point over the next few months before things turn back around. A brief, shallow inversion won’t signal any marked slowdown in the economy. Over the past several decades, the yield curve has had to invert by two percentage points or more before a recession materialized.
One bond portfolio manager noted that the market seems to be priced for
the Fed to start easing rates as soon as it stops tightening them." (emphasis added).
Any good technician will tell you never to anticipate a breakout or technical signal. Thus, declaring a recession to be inevitable based on an imminent inversion — or a non-recession based upon a short, mild inversion — may not be the best market call.
Nonetheless, any inversion — even a shallow and brief one — would ratchet up an
already elevated anxiety level in the bond market, as "investors worry
about a cooler housing market, inflation and energy prices,
particularly high home-heating bills" notes the Journal. And that’s before getting to Mortgage Equity Extraction, Current Account Deficit, a shopped out consumer, an expensive ongoing War, and assorted ills left over from the equity bubble’s collapse.
An inverted yield curve is not a guarantee of a recession, but it is nonetheless a worrisome thing. If it doesn’t foretell a recession, its not because "its different this time;" rather, its more likely because only some conditions precedent will have been met . . .
UPDATE: December 27, 2005 5:13pm
That didn’t take very long, did it?
Stocks tumbled Tuesday as the bond market gave signals that in the past
have preceded economic slowdowns. The Dow Jones industrial average lost
more than 100 points.
The yield curve, the spread between the yields
of short-term and long-term bonds, inverted for the first time in five
years. That means short-term interest rates were higher than long-term
interest rates. Investors have been watching the yield curve closely
because, in the past, inverted yield curves have preceded recessions.
The yield on the 10-year Treasury fell to 4.341 percent, while the two-year Treasury note closed at 4.347 percent.
lenders receive higher interest when they commit their money for a
longer time. A surge in demand for short-term credit can flatten or
invert the yield curve.
The last time the yield curve was
inverted was 2000, Charles H. Blood Jr., senior financial markets
analyst at Brown Brothers Harriman & Co. At the time, "it served
its classic function of a warning," he said.
Investors have been
watching for months as bonds’ long-term yields and short-term yields
grew closer. "Although an inverted yield curve does not always imply an
economic recession, it has predicted a profit recession 100 percent of
the time," Merrill Lynch’s North American Economist David R. Rosenberg
said earlier this month.
Dow Finishes Down 106 at 10,778, Nasdaq Finishes Down 23 at 2,227 As Yield Curve Inverts
Yield Curve May Become Inverted
Rate of the 2-Year Treasury Is Likely to Rise as 10-Year Flattens, Sparking Concern
DOW JONES NEWSWIRES, December 27, 2005