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 . . . 

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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.

Normally,
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

http://biz.yahoo.com/ap/051227/wall_street.html?.v=11

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Source:
Yield Curve May Become Inverted
Rate of the 2-Year Treasury Is Likely to Rise as 10-Year Flattens, Sparking Concern
SHAYNA STOYKO
DOW JONES NEWSWIRES, December 27, 2005
http://online.wsj.com/article/SB113564180391131729.html

Category: Federal Reserve, Fixed Income/Interest Rates, Inflation, Technical Analysis

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

16 Responses to “Inverted Yield Curve: Its different this time (not)”

  1. me says:

    We need to remember that “its different this time” Greenspan never was much of an economic forecaster.

    About those gas bill? My mother is going to call the gas company because “it must be wrong,” even though I have been telling her watch out.

    My sister-in-law ives in a small house and received a $300 gas bill. The thermostat is at 65 and they wear hooded sweatshirts and hats. The registers are turned off in unused rooms.

    I think when this reality sets in it will not be pretty.

    Already here in Georgia republicans are worried becuase GA has deregulation and pays the highest reate of any contiguous state, so they will be suspending 2% of the sales tax. Good luck chumps, 2% of a $500 gas bill will do nothing.

  2. Emmanuel says:

    Surprisingly, I agree with Greenie: it’s different this time, the only thing is it’s worse for all the reasons outlined above. The fiscal situation of the government and consumers is plain dreadful. Are retail sales as “solid” as some of the reports indicate they were? I’m glad Wall Street is happy with even more dissavings. This is the stuff of a supply-sider’s wet dreams.

    Another year of dissavings and soon Main Street USA will look like “Cabaret”, with people whoring themselves out on the streets for food. Come to think of it, Greenie looks like Fred Fosse, albeit with less hair.

  3. Inverted Yield Curves Spell the Utter Destruction of Mankind

    I first saw the news on The Big Picture about the upcoming Inverted Yield Curves, then later on CNN.Money.com.
    Despite the Dire Predications and Prognostications, an inverted yield curve by itself doesnt mean much except that bond buyers (which…

  4. Fiat Lux says:

    Yield Curves and Thin Ice

    Of the many bits of macroeconomic esoterica I studied this semester, one that particularly caught my interest was the bond yield curve. Normally, long-term bonds pay more interest than short-term ones, because you have to lock…

  5. Fred says:

    My gas bill for a forty year old three bedroom ranch was $109.49 on the December billing which is mostly November gas use. This is in Northern Wisconsin where it gets colder than Georgia but, homes in Wisconsin are insulated.

  6. Dave Singer says:

    ALERT ALERT CNBC REACHES ULTRA OBSCURE EXPLANATION LEVEL…

    1st day of Santa Claus Rally = Dow down over 100 pts.

    2 to 10 Inversion = Different this time, Because “Greenspan said so.”

    Huge drop in Nat Gas and NRG sector = “the reason the market was down”.. not a bona fide reason for it to take off…

    Ritholtz keep Doin your thing!!!

    Peace…

  7. Thinking clearly about the yield curve

    Barry is like the farmer who thought the sun would no longer rise after his rooster died. He has observed a correlation and has inferred causation. The yield curve is an indicator of something, not a cause. Ask yourself this question: Would U.S. ec…

  8. Michael says:

    Barry,

    Have you done or do you have research handy showing how the market has fared when the yield curve becomes inverted?

  9. Algernon says:

    It is different this time. The reason an inverted or even flat yield curve is associated with recession is that it implies tightening supply of credit. It is different this time because the tightening attempted by the Fed is being countered by foreign creditors buying 10-yrs.

    The critical question for long-term economic health is whether these foreign creditors are genuine savers or whether the liquidity being supplied us is primarily generated by Asian central banks with freshly printed yuan & yen. Anybody know the answer to that critical question?

  10. B says:

    It isn’t different this time NOW for sure. I don’t doubt there is a savings glut and I don’t doubt it has artificially kept rates down.

    But, the ten year has been cratering of late. I’d be very surprised if that has anything to do with any glut because this time the squirrelly bond market is validating a squirrelly stock market whose internals have been pretty unimpressive to downright ugly in this last rally. The internal structure of the equities market is a change from all other rallies in this bull market. Therefore, it is extremely improbable this is a takeoff point for a serious multi-leg rally. Taken with the bond market action, it is surely signalling a mid-party mess. The only question is likely how much. Downright bear market or multi-month/quarter correction before another explosive rise.

    Head and shoulders on crude also is possibly playing out a reduction in demand due to a slow down and a much needed crushing of the crude market manipulators. Can you tell that I want these hedge funds destroyed? Demand for crude and all other commodities has a high correlation to new players as much as global demand and I’d love to see them get their head handed to them. Who knows, maybe the Fed can manipulate that market for the good of all of us. It seems the Federales are involved in all kinds of sneaky sh*t including spying on us. If that’s the case, why not do some good with the sneakiness and crater the oil market for the good of the economy? :) A joke!

    The potentially complex topping pattern that began as early as January 2004 in equities ….if…..played out to its fullest would likely yield a downside of 83-8500 on the Dow. Just one possible target and less than Barry’s call. I’m not convinced we’ll drop that far but pure chart analysis yields that as a possible target. Fib analysis is a more moderate 9500ish as a downside target.

    Be interested in Barry’s analysis of how he came to 6800. Not that we get the benefit of that work on a free blog but…..hey, I can ask.

  11. B says:

    Oops, Fib also shows 8500. Fumbling fingers.

  12. Yield curve inverts

    The yield curve on US Treasury yields, inverted today, an event which has frequently signalled the beginning of a recession:
    The Globe and Mail: Bonds spark growth worry
    Here is the historical record we have endured eight Fed tightenin…

  13. Some Strong Support for Barry from Studies

    There is very strong support for the yield curve association, and I’ll link to some sources below. Barry’s analysis is more carefully qualified than that of most of the talking heads on CNBC. Until now, I have always believed in

  14. someone said:

    It is different this time because the tightening attempted by the Fed is being countered by foreign creditors buying 10-yrs.

    The critical question for long-term economic health is whether these foreign creditors are genuine savers or whether the liquidity being supplied us is primarily generated by Asian central banks with freshly printed yuan & yen. Anybody know the answer to that critical question?

    It’s Asia, baby — the only thing keeping this abysmally indebted, cheeseburger & credit nation afloat.

    Watch out market in ’06 — looks like the best way to make dough will be by shorting OSTK till it hits neighborhood 17 smackerville, quite the ‘burb from what I hear.

  15. Thinking clearly about the yield curve

    Barry is like the farmer who thought the sun would no longer rise after his rooster died. He has observed a correlation and has inferred causation. The yield curve is an indicator of something, not a cause. Ask yourself this question: Would U.S. ec…