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Yield curves and recessions

By Peter Morici
web posted March 26, 2007

For the past month, the interest rate on 10-year Treasury bonds has dipped about a half a percentage point below the yield on a three-month Treasury note.

In a solidly growing economy, investors expect to receive higher interest rates, or yields, when they tie up money for longer periods, and the inverted yield curve we now observe is causing speculation that a recession is imminent.

Don't bulk up your stock portfolio with recession proof investments like utilities. This time more inflation is as likely as a recession.

Historically, long rates dip before recessions because investors expect growth to slow and short-term interest rates to decline within a few months. However, over the last six years, four factors have disrupted relationships between long and short rates, and old rules may no longer apply.

First, in 2000, stocks had become hugely overvalued thanks to the high tech frenzy and accounting improprieties. The market bust drove investors to safer places, including long-term bonds. That bid up bond prices and lowered yields, even as a booming housing market soaked up massive amounts of long-term financing.

Second, China and other Asian central banks have been soaking up Treasury securities to keep their currency values low against the dollar, exports cheap and domestic economies booming. Those purchases are not yield sensitive, and their massive size pushes down long-term bond rates.

In June 2004, the Federal Reserve began raising the federal funds rate. Since then, by purchasing U.S. short-term securities, the Fed has added only about $78 billion to currency in circulation and bank reserves that back up loans. That is not much in a $13 trillion economy, and the prime rate on short-term business loans has risen from 4 to 8.25 percent. Meanwhile, foreign central banks have purchased more than $750 billion in U.S. securities, and the rate on 30-year conventional mortgages is hardly changed at 6.2 percent.

Third, an aging population has a preference for more bonds and fixed income securities. The eldest baby boomers are now 62. No one should be surprised that the demand for long bonds is up and yields are down.

Fourth, in recent years, the Federal Reserve has established greater credibility as an inflation fighter, and this has caused many investors to assume long bonds are less risky than in the past.

All this is good and bad for the U.S. economy.

The good news is the housing market will continue to be supported by Chinese and private investor purchases of Treasury and other fixed income securities. The housing bubble warrants a correction in land values but as long as long bond rates stay low, the correction will be mild. Prices on existing homes won't fall a great deal. Prices may stay flat for several years but homeowners, unlike the bust of the early 1990s, will be able to sell their properties.

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

This comes at a time when prices for key commodities like crude oil and iron ore are determined by hyper growth in China and elsewhere in Asia. Those forces are driving up gasoline and other material prices. Gradually, this has pushed up inflation for other products too.

Also, labor markets are tight because competition from Asian imports, advantaged by undervalued currencies, are pushing workers out of manufacturing and into services, but those workers lack skills for hard to fill vacancies in finance, computer services and other booming service activities.

Consequently, getting inflation below two percent, as Chairman Ben Bernanke would prefer, would require draconian tightening of short-term interest rates by the Federal Reserve. That would cause a long recession and painful recovery with real incomes falling for several years.

In the end, the Federal Reserve is as likely to leave interest rates unchanged for the balance of the year, accept more inflation and skirt a recession. ESR

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

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