Inverted Yield Curve: One Step Away from Recession

Predicting a recession or economic slow down in the United States economy, is not always an easy forecast by many economist or Wall Street experts. Also, trying to anticipate a change in the business cycle. However, during the past century an inverted yield curve or “negative yield curve,” has predicted US recessions or weakening economy, by the bond market, six out of eight times. An inverted yield curve occurs, when US Government long – term debt instruments (Example: 30 year US Bond) or bonds yield less than short – term debt instruments
(Example: 10 year US Bond), and have the same credit quality rating. Normally, investors expect to receive more interest for long term bonds than short – term securities. The inverse yield, between long and short – term bonds, happens very rarely and considered to be a predictor (not always) of an economic recession or entering a period of slow economic growth, a year later or sooner.

During the past year, and beginning of 2006, Federal Reserve Bank has been tightening liquidity or increasing interest rates. Their monetary concerns, preventing inflation or economic speculative growth. Also, by raising interest rates, this stabilizes the value of the United States Dollar, trading against other currencies. This creates a favorable environment for foreign investors to purchase hard assets, including real estate in the United States, and US securities. Besides, a strong US Dollar currency will help maintain low import prices. Certainly, the value of the US Dollar against other currencies can change detrimentally, when the US economy shows signs of a slow down. Unfortunately, history has shown, the Federal Reserve Bank often over extends their economic policy, either by raising or lowering interest rates to far (In 2003, the Federal Reserve Bank had lowered the Federal Funds Rate down to one percent). The effects of monetary policy, has rippling effects in the future, either by to much stimulus and growth or leading the economy, into a slow down or possible a recession. Many times, Economists or bond market participants anticipate, the US economy may slow down, by an approaching inverted yield curve. The longer an inverted yield curve remains or the wider yield between short – term and long -term bonds, is an ominous predictor for a future recession or low economic growth. Often, this reflects a down slope in the business cycle.

Evidence indicates an inverted yield curve leads to a possible recession. In 1996, Federal Reserve Bank economists Frederic S. Mishkin and Arturo Estrella, published a paper, which outlined that an inverted yield curve, would predict a recession. Regarding this report, had shown every US recession post World War Two Era, had preceded an inverted yield curve.
Furthermore, subsequent papers written by these economists, attributed the best economic indictor out of twenty-six, as an inverted yield curve, that predicted recessions four – six months in advance. Reported in the Street.Com on December 5, 2005, Tony Crexcenzi, chief bond market strategist at Miller Tabakand and contributor, mentions that an inverted yield curves since 1970, has been followed during a period of time, when Standard & Poors 500 earnings growth was negative, which had proceed an economic slowdown or recession. Prior, last recession in 2000, economists failed to recognize or ignored the prior inverted yield curve. Fortunately, the previous recession was considered mild compared to others, which were more severe and lasted longer. Based upon past history, when the yield curve becomes inverted for ninety days or more, that foreshadows a recession within twelve months.

An inverted yield curve does not always, accurately predict a future recession. In 1988, a false indication of a future recession had been proceed, when bond yields inverted. The circumstances leading to this inverted yield curve, attributed to investors buying long – term government bonds, which caused prices to fall and yields to drop. This happened, because investors concerns, during the time of financial troubles within hedge funds. The concerns were proven to be temporary. Most recently, the Federal Reserve Bank has been raising interest rates gradually, in the background of modest inflationary expectations, compared to previous times, when inflation was a concern, prior to a recession.

Consequences of an inverted yield curve are many. United States and foreign investors are less likely or will retreat from purchasing long – term bonds, since the yields on short – term instruments, provide a better return on their investment, and a short duration, holding onto these debt securities. Lending institutions or banks, relying on lending money for long – term duration, will have fewer borrowers. This will negatively affect, their corporate income, and may cause these lending institutions to cut back on expenditures, which affects their employees, and future lending goals. Sometimes, these lending institutions will then pursue risky investments or unwarranted lending practices, trying to earn, other sources of income. During the time Federal Reserve Bank increases interest rates, this often curtails the real estate market growth, by requiring borrowers to pay a higher interest rate. The slow growth or negative impact on the real estate market, one of many factors, underlying reason for an inverted yield curve, related to slow economic growth or possible future recession. The flattening of the yield between short and long term rates, and could lead to an inverted yield curve, and causes many investors to pursue, more risky investments in the equity or fixed income markets. The risk of speculation, often implode upon a disastrous outcome or financial loss, based upon unrealistic financial outcomes. This maybe perceived to some investors, as a future stock market crash or correction. Finally, the Federal Reserve Bank then changes their monetary policy from raising interest rates or maintaining a neutral stand to lowering interest rates, which to stimulate the economy.

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