The curve is inverted, the curve is inverted. The yield curve finally inverted last week, at least slightly. The New Year will show whether that occurrence was a trivial blip or a reliable warning.
As economic indicators go, the yield curve is pretty esoteric. It shows how interest rates vary with the length of time money is borrowed. The time scale commonly runs from three months to 10 or even 30 years.
To make sense, the interest rates must be for loans with equal risk. In comparing 30-year mortgage rates with five-year boat loan or one-month credit card bills, the difference in collateral and risk is much more important than length of time. The yield curve shows interest rates over time with risk factored out.
U.S. government bonds are the safest in the world. Interest rates on bonds that will mature over periods from 13 weeks to 30 years are available every business day. These are used in constructing the yield curve.
In such low-risk government borrowing, long-term rates usually are higher than short-term rates. We usually have better information about what will happen in six months than over 30 years. Better information means lower risk. Lower risk means lower interest rates.
If you lend the government money for 13 or 26 weeks, little can happen to make your investment turn out differently than you expected. Over 10 or 30 years that is not as true. Yes, the interest rate is guaranteed when you buy a government bond. Yes, our government has never defaulted on a bond payment. But other things can happen that will affect the relative profitability of buying long-term government bonds.
If inflation is higher than anticipated, the money you get back from the government may buy less than the money you put in did. If alternative places to invest turn out to provide superior returns, tying money up in long-term treasuries will be a bad decision in relative terms.
Thus short-term rates usually are lowest. Rates trend up smoothly as the length of time the money is loaned increases. Long-term rates often are 1 to 2 percentage points above short term ones.
There are times, however, when short term rates rise — or long term ones fall — so that the curve becomes inverted. That is, short-term bonds pay higher interest than long-term ones. This may reflect market opinions that inflation will be lower in the long-term than thought or that the central bank — the Federal Reserve in our case — will raise short term rates.
Unfortunately both conditions — falling inflation and tighter money — are associated with recessions. When the yield curve becomes inverted — as it did at least briefly last Tuesday — a recession often follows.
Unfortunately, an inverted curve is not a 100 percent reliable recession alarm. Nor is the lag between the date it inverts and the onset of recession very consistent. Take this week’s news as a tentative warning. Don’t treat it as infallible.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.