Inverted Yield Curves and Recessions
By Dr. Peter Morici, Professor of International Business

Yesterday, the yield inverted. The yield on the ten year Treasury dipped below the yield on the two year Treasury setting off speculation that a recession is around the corner.

Bank One Financial Advisors Chief Economist Anthony Chan observed that the yield curve predicted the last five recessions. Comments like that will add greatly to investor unease and could tank the fragile stock market recovery of recent months.

What is important to recognize is: in the past, long rates have dipped before recessions because long rates were depressed by some of the same factors that caused economic slowdowns. For example, business pessimism about future demand and inflation caused rates to rise and subsequently for business investment to tail off. However, through the recent economic recovery and thirteen Federal Reserve increases in the Federal Funds rate, longer term rates for Treasury, Corporate and Mortgage-backed bonds have remain stubbornly low.

Long rates have become unhinged from short rates, the general pace of economic growth and the factors that cause business cycles.

Over the last five years, four sets of factors have contributed importantly to long-term rates that stay low in the face of a rapidly expanding economy, Fed efforts to boost interest rates and huge demand for mortgages.

First, by 2000, stocks had become hugely overvalued thanks to the high tech frenzy and the accounting improprieties that caused investors to believe companies were more profitable and worth more than was indeed the case. The stock market bust that followed drove investors to safer placeslike medium and long term bondsand this bid up bond prices and lowered yields, even as the economy expanded and the housing market soaked up massive amounts of long-term capital.

Second, foreign central banks, such as those China and other Asian countries, have been soaking up Treasury securities to keep their currency values low relative to the U.S. dollar and their exports and domestic economies booming. These purchases are not yield sensitive, and their size drove down medium and long-term U.S. bond rates.

Third, an aging population has a preference for more bonds and fixed income securities. The first baby boomers turn 60 on January 1. No one should be surprised that the demand for long bonds is up and yields are down.

Fourth, unprecedented improvements in productivity, more intense international competition, lots of excess manufacturing capacity in the wake of the late 1990s Asian debt crisis, and imports assisted by undervalued Asian currencies have kept prices for everything but petroleum, natural gas and related products in check.

For a long time now, I have argued that the Fed is worrying too much about inflation, because these factors are keeping prices in check. Look at retail prices for furniture, electronic and cars!

In all of this, there is good news and bad news.

The good news is that the housing market will continue to be supported by Chinese and private investor preferences for Treasury and other fixed income securities. The speculative bubble of the last several years warrants a major correction. As long as long bond rates stay low, the housing market correction will be mild.

The bad news is that Chinese and other foreign government intervention in currency and bond markets have dramatically reduced the potency of Fed policy. Central Bankers in Beijing, Hong Kong, Soul and other places due east now have as much to say about U.S. monetary policy as the Fed.

We will only have a recession if the Fed, in its frustration, pushes short rates too far. Then the housing market would collapse, just like stock prices post 2000.

Peter Morici is an economist and professor at the Robert H. Smith School of Business, University of Maryland. Prior he served as Chief Economist at the United States International Trade Commission and is a member of the Bloomberg and Reuters forecasting panels.