Tuesday, March 13, 2007

Yield curve prophecies

The bond market has, historically speaking, generally predicted an outlook for the economy through the shape of the yield curve. Today we have in the U.S. an inverted yield curve in which short term interest rates are higher than long term interest rates. Since 1960 there have been seven periods with an inverted yield curve, and six of these periods were followed by a recession. This is well known but since the consumer has not yet heard the news, the equity markets, however edgy now, remain reasonably resilient.

A positive yield curve, on the other hand, indicates a healthy outlook for the economy and this of course seems like common sense. Shouldn't an investor in a 10 year Treasury or corporate bond get paid a higher interest rate for taking that longer term risk than, say, someone buying a 6 month CD or stashing their cash in a money market account. But today, with an inverted yield curve, the bond market is saying one of two things: either the economy will slow significantly and those short term rates that seem like such an easy choice today for safety will begin to stairstep down until they are below long term rates; or the globalization of markets and the U.S. trade deficit have created such strong demand for U.S. securities that this inverted yield curve is an anomaly and cannot be seen to have the same predictive power.

Which is it? You won't find the answer here, but looking at global markets there are patterns in yield curves today. Along with the U.S., those countries with similar inverted yield curves are Britain, Canada, Australia, Singapore, and Thailand. The Euro area has, roughly, a flat yield curve. So does Hong Kong. Countries with modestly positive yield curves are China, Mexico, Taiwan, India, Norway, Sweden, and Switzerland, and countries with distinctly positive yield curves are Japan, the Czech Republic, and Poland. Excluded from this list are countries like Brazil, Venezuela and others in emerging markets that issue long term debt in dollar denominated form. Russia, with a radically inverted yield curve, is an outlier.

By traditional standards of yield curve predictive power, the above would suggest that the English speaking financial powers are headed for a slowdown, Europe and emerging Europe will maintain some slow, maybe even sluggish, growth, and Asia will continue to maintain, while not uniformly, a higher growth rate. Russia is fine if energy prices stay high but will collapse if they do not.

And how does this post conclude. It really doesn't.


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