Tuesday, December 27, 2005

Inflation Worries Rise on Inversion

The yield curve, which represents the difference between the 2-year note and the 10-year note, inverted today, which in the simplest terms means that it costs more to borrow money for a short period of time than it does for a longer period.

This is not desirable. In fact, it's usually a telltale sign of an oncoming recession.

We talked about this back in August, when the 30-year rate fell to 5.77 percent.

Guess why long-term rates keep falling? Think it has something to do with home loan volume falling off the edge of a cliff? If you think people are still buying those adjustable rate mortgages (ARMs), you might want to check reporter Ruth Simon's Wall Street Journal story published last month.

Likewise, you will be interested in this Bloomberg News story of Dec. 25, which reports that "The number of mortgage applications fell to the lowest level in nearly a year, according to an index by the Mortgage Bankers Association."

Every day the so-called Chicken Little's get more evidence to support their side.

This from today's Marketwatch story:
Treasurys were higher Tuesday after the spread between the 2-year note and the 10-year note inverted for the first time in five years.

An inverted yield curve occurs when short-term maturities pay a higher interest rate than longer-term maturities.

Such an unusual event typically has foreshadowed a noticeable economic downturn. Usually, a recession has followed.

Despite the warning signs in the Treasury market, however, few economists expect a recession in the next year. This time, they say, things are different.

With an inverted yield curve, banks can no longer make money by borrowing short-term money and lending it at longer terms.

The inversion first came in European trades when the 2-year note yielded 4.411% vs. a 10-year yield of 4.405%. The curve briefly inverted in late-morning and late-afternoon trading.

Treasurys continued to rally modestly throughout the session.

By the end of regular trading, the yield curve had normalized a bit with the 2-year yielding 4.343%, while the 10-year yield stood at 4.349%. Still, a large part of the yield curve was still inverted, with 5-year notes yielding 4.29%, just 4 basis points more than the overnight federal-funds rate of 4.25%.

"The market has been pressing for curve inversion for several weeks," said economists at Action Economics, who said they expected it would be a temporary development.

The last time the yield curve inverted was in 2000, before the last U.S. recession and a period of aggressive rate cuts by the Federal Reserve. The yield curve briefly inverted in 1998 during the Asian financial crisis -- the only time in the past 30 years that an inverted yield curve has not preceded a recession.

Some economists continue to eye the yield curve as a critical economic indicator. Others say it's lost its significance because special factors, such as the government shifting issuance to shorter maturities, have distorted the curve's economic signals.

An inverted curve doesn't cause economic weakness, although it has been correlated with weakness in the past, said Bill Dudley, an economist for Goldman Sachs. He argued that tight monetary policy is the underlying cause of most slowdowns.
This from today's Reuters story:
U.S. Treasury debt prices rose for a third straight session and 10-year yields were pushed below two-year yields for the first time in five years possibly signaling U.S. economic growth could slow in 2006.

Recent benign readings on inflation and signs of fraying in the housing market have dragged down longer-maturity yields recently, while expectations for at least one more Federal Reserve rate hike have held short-term rates steady.

The benchmark 10-year Treasury note jumped 10/32 in price for a yield of 4.343 percent, a two-month low, down from 4.378 percent on Friday.

Meanwhile, two-year note yields were at 4.351 percent, down from 4.364 percent, leaving the yield spread at an inverse of almost one basis point.

"The curve should be flattening if the Fed is assumed to be still tightening," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi.

A roughly one percent drop in major U.S. stock indices, also tied to worries that slower growth is on the cards, helped put a bid under bond prices as the day progressed. The Dow Jones industrial average shed more than 100 points.

An inverted yield curve has preceded the last four U.S. recessions, although not every instance of an inverted curve has been followed by a recession.

"We believe that the two-year note has room to cheapen," said strategists at BNP Paribas. With 10-year note yields rangebound, "there is yet further flattening room in the curve," they said.

— The Boy in the Big Housing Bubble