Wednesday, May 25, 2005

Fed May Generate Inverted Yield

Over the past 25 years, the difference between long term rates, such as the 10-year U.S. Treasury, and short term rates, such as the 6 month U.S. Treasury, has dipped below zero (termed an inverted yield) very few times. However, each time that it has, the U.S. economy entered a recession.

Since 1959 the 10-year U.S. Treasury has exceeded the 6 month U.S. Treasury by an average of 1.46 percent. However from November 1980 to August 1981, the yield was inverted or negative. According to the National Bureau of Economic Analysis, the official recession dating organization, the U.S. entered a recession in July 1981. NBER determined that the next recession began in July 1990. While the yield did not decease below zero, it did plummet to an average of 0.37 percent between June 1989 and March 1990. According to the NBER, the next recession began in March 2001. In advance of this recession, the yield once again was negative or inverted. The difference between long rates and short rates was negative between August 2000 and December of 2000. At no other time between 1981 and 2005 did the yield drop below zero.

Why does a negative or very low yield signal a recession or slowdown? The Federal Reserve (Fed) determines short term rates, while the market determines long term rates. Thus when the Fed judges that inflation is excessive, they raise short term rates to cool inflation and slow the economy. If the market, made up of individuals across the globe, estimate that inflation is low and growth moderate, long term interest rates will remain low. In this case, short term rates rise while long-term rates decline or remain low and the yield becomes inverted. Thus inverted yields result essentially from Fed mistakes.

In June 2004 when the yield was 3.46 percent, the Federal Reserve began the first of eight interest rates hikes. By May 2005 as a result of the Fed action, the yield declined to 1.25 percent or slightly below the historical average. Moreover, the Fed has indicated that they will raise rates again at their next meetings June 29/30. In my estimation, further rate hikes will slow the U.S. economy below Fed intentions and market expectations.

Ernie Goss

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