Blog: Spirit of Money, Financial Fluidity
by munificent


No One really knows the whys and wherefores...And often Buffett, and Gates, and Bush, and Greenspan decide to influence by just saying "their truth" -And so it is!- It works for them...Power goes to whom we allow it..The last time we had inflation in fuel-it was stag flation and Jimmy Carter was president

Date:   12/29/2005 9:27:02 PM   ( 16 y ) ... viewed 1515 times

By Mike Dolan, Economics Correspondent

WASHINGTON (Reuters) - Head-scratching over whether this week's U.S. yield-curve inversion is a true bellwether of recession is merely a new spin on a hoary old problem that has puzzled economists all year.

Rather than some ill omen, the inversion -- an unusual rise in two-year borrowing rates above 10-year rates -- has occurred because long-term rates have remained stubbornly low or fallen as the Federal Reserve has jacked up short-term rates.

While economists have a plethora of theories, few still have a watertight explanation for why 10-year borrowing costs are lower now than when the Fed began a campaign that has more than quadrupled short-term interest rates.

It is this "conundrum" -- the term Fed chief Alan Greenspan coined for the puzzle back in February -- that lies at the root of the U.S. economy's remarkable resilience this year.

Until it is better understood, many economists believe that trying to read the tea leaves of this week's peculiar bond market configuration is a wasted effort.

"Mr. Greenspan's 'conundrum' is a central issue here and asks whether the yield curve today means what it used to mean," said Anirvan Banerji, director of research at forecasting firm Economic Cycle Research Institute. "Even if it does mean what it used to, the record is still pretty patchy anyway."

Banerji said the most-watched yield curve for economists studying the business cycle was the 3-month-to-10-year gap. Using average monthly interest rates, that rate gap did not signal the 1990/91 recession. It also failed to predict three recessions in the 1950s and 1960s and gave a false signal of a recession that never occurred in the mid-1960s.

Not least because the two-year note has only been around for about 20 years, Banerji reckons the 2-year-to-10-year rate gap is even less reliable, and says it gave a false alarm of a recession that never happened in 1998.

ECRI, which claims to have been one of the few forecasters to flag an impending downturn early in 2001, said its leading indicators predict an acceleration in the manufacturing sector in the next few months and only some aggregate slowdown late in 2006.

"The outlook for the second half is shakier -- but we do not see any sign of recession here," said Banerji.

But whether the yield curve predicts recession or not, most economists say it is still critical to heed signals from the bond market.

ECRI, for example, includes bond yields in its leading indicator indices but factors in falling yields as a growth stimulant rather than an ominous sign of slowdown ahead.

The Conference Board, for example, changed in June the way the yield spread affects its leading index of where the U.S. economy is heading. A falling yield spread between short and long rates no longer acts as an outright negative for future economic prospects.

This is why the nature of the current inversion is key.

Even if you believe the oracular power of the yield curve, all inversions that have correctly flagged recession in the past have come when short-term rates were rising more quickly than long-term rates were. In other words, the whole horizon of borrowing rates was rising.

This time, long-term rates have actually fallen as the Fed has pushed up short rates.

Ten-year yields at 4.34 percent are nearly a third of a percentage point lower than when the Fed started its series of rate rises in June 2004. That is a powerful spur to long-term borrowing and financing -- both for corporations and households -- and key to keeping the housing market afloat.

This is the heart of Greenspan's conundrum, a puzzle he claims to have resolved with reference to globalization and increasingly international flows of savings and capital.

"There are a lot of unique factors in this particular episode that make the yield curve even less reliable than usual," Banerji said.

There is no shortage of theories about culprits in the conundrum.

One major suspect is huge stockpiling of currency reserves in Asia and oil-producing countries because the recycling of those funds back into U.S. bonds boosts demand and helps depress long-term U.S. interest rates.

Demand is also growing from U.S. pension funds, which are faced with the prospect of new regulations and want long-dated fixed-income securities to better match long-term liabilities.

Some say corporations, after a financial squeeze and accounting scandals that followed the 2001 stock market crash, have been wary of new borrowing despite rising profits and full coffers. This lack of corporate bond supply has helped keep long-term rates low.

Others say the puzzle hinges on inflation expectations.

Nearly all inflation measures, despite relatively subdued non-energy prices, are higher than 18 months ago. Economic growth remains well above long-term averages, with economic slack all but disappeared and the economy expected to grow briskly again next year.

So why are investors demanding less compensation against inflation for lending for 10 years than they do for two years?

"We feel inflation expectations have a lot of inertia even though I believe the inflation cycle has turned," said Larry Kantor, head of global research at Barclays Capital.

"After 25 years of declining inflation, it's not that surprising that it takes a while to turn those expectations around," he said, noting it took years for the bond market to adequately compensate investors for the 1970s inflation spike.

"Investors, having been beaten up by unexpectedly high inflation in the 1970s, then had a pretty big risk premium in the early 1980s even though (then Fed Chairman Paul) Volcker was determined to get inflation down and keep it down."

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