Inverted yield curve worsens -- Is a recession looming?

October 4, 2006

Especially in this last month, bond market investors have been forecasting a recession via a phenomenon known as an inverted yield curve. As of Monday, the 1-year bond returned 4.9% interest, while the 2-year bond returned only 4.66%. Typically, the rates on long-term bonds are higher than short-term bonds because investors want a better return for tying up their money for a longer time.

For this reason, long-term interest rates are a forecast of what the most sophisticated investors think short-term rates will be when the bonds come due. Today’s bond investors believe that, two years from now, an interest rate of 4.66% would be better than the short term rate.

Bond investors are even more pessimistic further out. Yields for 3-year bonds are 4.59%, and for 5-year bonds are the lowest of all at 4.56%. Bond investors don’t think the economy will improve until 10 years out, when the yield is 4.62% , and at 20 years, the yield is 4.83%...higher, but still not as good as the 4.9% rate currently offered on 1-year bonds.

What It Means:
An inverted yield curve means short bond rates are higher than long bond rates. The conventional wisdom is that these investors are willing to tie up their money for this long at a lower rate because they believe they will actually make more than if they kept buying and reinvesting in short-term bonds which will return much less in the future than they are now. For this reason, an inverted yield curve usually occurs before a recession, as it did before the recessions of 2000, 1991, and 1981.

However, some unusual things have been happening in the U.S. bond market. China, Japan and oil-producing nations have been unusually interested in buying long-term bonds for reasons other than their return.

• China wants to keep the value of the dollar high, so they can sell their goods to the U.S. consumer at a comparatively lower price.
• Japan has been trying to pump money into their economy to create inflationary pressure to combat 10 years of deflation. The best way to do this is to print yen, and use the excess to buy U.S. Treasuries.
• The oil producing nations have been buying Treasuries as a safe place to keep their extra dollars until they can reinvest them in their own economies.

Action Steps:
Hope for the best and prepare for the worst. What would you do if you knew a recession was coming in the next year? Would you save more, defer unnecessary purchases, get a better job? Although there are good reasons to believe we are headed for a soft landing, an inverted yield curve is a red flag, and a good excuse to make financial planning a higher priority.

Sources: U.S. Treasury web site, Federal Reserve Board of Governors web site, “Economic Outlook for the United States”, Remarks by Federal Reserve Vice Chairman Roger W. Ferguson, Jr. at the Howard University Economics Forum, Washington, D.C., March 3, 2006, “The Yield Curve as a Leading Indicator: Frequently Asked Questions”, Arturo Estrella, October 2005.