A Warning from the Bond Market?

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The world turned inside out on Tuesday, when short-term interest rates inched higher than long-term interest rates. That's not the natural order. On Wall Street, this rate flip-flop is known as an inverted yield curve. It's a relatively rare occurrence, and one that always drags out economic Chicken Littles. But the sky is not falling on this expansion just yet.

Yes, some clouds are gathering. "The risk of recession is clearly higher," says James O'Sullivan, economist at UBS Securities. "But it's far from certain." He estimates that growth in GDP will slow this summer to about 2.5% from an estimated 3.5% to 4% in the first quarter. That's hardly a disaster. In fact, it's pretty much what the Federal Reserve hopes to accomplish with its long campaign of short-term rate hikes geared at keeping inflation under control and stretching out the recovery.

So why any angst? In a healthy economy, long-term rates should move higher as short-term rates move higher. That's how lenders get compensated for the extra risk that comes with longer payback periods. A 30-year fixed-rate mortgage rightly carries a higher rate than a 15-year mortgage, which rightly carries a higher rate than a 10-year mortgage, and so on.

Yet here we are: The 10-year Treasury bond, which is Wall Street's favorite gauge of long-term interest rates, hit 4.343% on Tuesday while the two-year Treasury bill, a benchmark for short rates, hit 4.347%. Put aside the fact that this inversion is minuscule, and had evaporated by mid-day Wednesday. Inversion is inversion, and this unwholesome circumstance has occurred before every recession in the last 40 years. The logic is simple. Bond traders push long-term yields unusually low when they feel that short-term rates are unusually high and will choke off business borrowing and crush the economy.

Trouble is, in that 40 years there were two instances when long rates fell below short rates—and no recession followed. The most recent case was in 1998, when short rates, as is the case now, were just barely above long rates and the economy chugged on mightily for two more years. Meanwhile, there is nothing unusual about today's short-term rates, which are just 2.5% above inflation. Short rates surged to 5% above inflation before the last two recessions (1990 and 2001). That's what triggered an inverted curve in 1989 and 2000.

What's abnormal today is how low long-term rates have remained, explained at least in part by China's and Japan's historic demand for Treasury bonds. Absent unprecedented foreign demand, Treasury bond yields likely would be well above short-term yields today—and Chicken Little would have no audience. That's not to say the yield curve won't invert again, and grow more pronounced. If it does, be warned. But we're not at the breaking point today, and may not get there for years.