Friday, March 23, 2007

Bond Markets: Inverted Yield Curve Still Dangerous

Bond Markets: Inverted Yield Curve Still Dangerous

Drivers pay attention to yellow Yield signs on the road, because it's dangerous if they don't. They could merge right into 18-wheelers roaring down the main road. The same holds true for the financial world and the economy. We've got to pay attention to Inverted Yield Curve signs, because it's dangerous not to. We could get run over by a recession. Why? Because history shows that recessions follow a period when yields are inverted, that is, when short-term interest rates are higher than long-term rates.

Although former Fed chairman Alan Greenspan recently gave recession a one-in-three chance before the end of the year, a recent Bloomberg article (3/12/07) pointed out that the "probability the U.S. economy will shrink for two quarters has risen to 50 percent, according to a model created when Greenspan ran the Board of Governors of the Federal Reserve System. The formula is based on differences in yields on Treasuries."

Well, what do you know? Seems that the Fed's economists are worried, too, even more than their former boss is. The two Fed economists who designed the study are willing to bet that the inverted yield curve is a strong indicator of recession. According to Bloomberg, the Fed economists' study said, "Treasury yields are a better predictor of recessions than stock prices. That's because relatively high short-term rates slow the economy while lower longer-term rates reflect the outlook for weaker growth and inflation, they wrote."

Bob Prechter draws conclusions from the inverted yield curve, too, and in his most recent Theorist, he includes a chart that's worth a thousand words – although we've included about 275 words to go with it.

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Excerpted from The Elliott Wave Theorist, February 21, 2007, by Robert Prechter

Inverted Yield Curve
Short-term interest rates have been above long-term interest rates—as measured by 3-month vs. 30-year U.S. Treasury debt—for six months. Such conditions occur at extremes in short-term lending for investment purposes. This condition in turn implies a peak in financial markets, which today more than ever rely upon speculative borrowing to keep them rising. Many observers have discounted the implication of the current “inverted yield curve,” because it has been in effect for a number of months with no reversal in stocks. History shows, however, that the indicator’s timing is almost always within a matter of months. Every passing month gives a reason to be more concerned about this condition, not less.

This chart of Yield Ratio vs. Stocks demonstrates the utility of this indicator. When the yield curve was negative in 1978-1980, the stock market underwent three “massacres” and persistently lost value in real terms. The stock market peak of April 1981 occurred after six months of a negative yield curve. The peak of 1989 in the Value Line Composite and Dow Jones Transports occurred four months after this condition began, and the high in the New York Composite index of September 2000 occurred two months afterward. After each of these latter two junctures, at least one market index fell at least 47 percent. The yield curve has now been inverted for six months. Essentially, it is right in the normal area when a reversal in the stock market usually occurs. [The subscriber] who brought this relationship to our attention, points out, “It fits perfectly with the expectation of the top occurring within the 1st quarter of 2007.”

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