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Thursday, February 10, 2005


inverted yield curve

as the american treasury-bond market has rallied yet again, the news from europe is that of a coincident rally which threatens to invert the yield curve, as has already occurred in the british market.

the yield curve is simply a plot of the yields of the various durations of treasury debt, from 30-day bills to 30-year bonds.

generally, lenders demand higher interest rates for longer obligations of debt because the lender assumes more risk over that time -- risk of the borrower's default, risk of rising rates that make this lending look poor by comparison. so the yield curve normally rises as it moves to the longer durations.

interpreting yield curves gives some insight on what the market expects of the economy. as markets set rates, the curve can steepen or flatten -- steeper curves implying that markets expect interest rates to rise over time, flatter curves that rate movement will be indeterminate. as rising interest rates accompany inflation and often a strengthening economy, steep curves are seen as harbingers of economic growth.

inverted curves -- where the longer-duration, more-uncertain yields are actually lower than the short-term yields -- are rare. the occurrence of an inverted curve suggests that rates are expected to decline over time, an event which would normally accompany recessions. the expectation of recession gives lenders reason to loan money for longer durations, locking in current rates prior to the expected decline.

the inverted curve can be a powerful indicator of trouble in the months ahead. (the yield curve in the united states inverted in early 2000, indicating the onset of the recession of 2000-2002, for example.) when accompanied by widening credit spreads, the implication is quite ominous.

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