The SanityPrompt

This blog represents some small and occasional efforts to add a note of sanity to discussions of politics and policy. This blog best viewed with Internet Explorer @ 1024x768

Friday, August 26, 2005

US Yield Curve is Flat: Ignore History at Peril

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"NEW YORK, Aug 26 (Reuters) - U.S. Treasury debt with a short-term maturity is close to yielding more than longer-term debt for the first time in four years, but few analysts are predicting an inverted yield curve yet."

The yield curve describes the interest rate paid on bonds of various maturity. Along the bottom of the graph you have the different bond instruments, 6 month, 2 yr, 5 yr, 10 year, 30 year. Along the side axis you have the interest rate. Ordinarily, you are supposed to get a higher rate of return the longer the instrument. But when the curve is inverted, you earn more money investing in short term instruments than in longer term instruments. Typically, this signals a looming downturn in the economy. The last inverted yield curve was in the early 1980s when Paul Volcker sent the economy into a free fall to cure it of stagflation.

The article indicates that many people no longer believe this wisdom applies, including Alan Greenspan. And it is true that longer term rates are down and it is not exactly clear why. I happen to think this has a lot to do with demographics. There is simply more demand for savings instruments than debt instruments right now among the baby boomers. Plus, the savings rates overseas are probably higher than they should be. But how long does all this last. Back before Greenspan drank the Kool Aid and bought into the new economy language, he warned against irrational exuberance by reminding his audience that technology had not repealed the basic laws of supply and demand. My own thinking on this is that we are likely to see a series of bubbles as the boomer generation looks for the next get rich quick scheme where they can park their money. The bond market right now just sets up the housing bubble. The article ends by warning:

But more ominously, some see the flattening curve and the possibility of inversion reflecting real risks to the economy. Record oil prices could fuel inflation, cause consumers pinched by those high costs to start scrimping and return the economy to the "stagflation" of the 1970s, in which low economic growth was combined with high inflation.

"Traditional measures are worth watching," said David Ader, fixed-income strategist at RBS Greenwich. "History has generally been a good guide. "The flat yield curve may not be telling the exact same story as it did in the past, but it is not fair to ignore it entirely."


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