Inverted yield curve predicts recession in US

Jan 2006


Historically at least four of the last recessions in the US have been preceded by what economists refer to as an inverted yield curve.
What this means is that long term interest rates are   lower than short term rates. This situation is the reverse of the norm because normally one expects yields to be greater on long term bonds than short term ones to compensate for the longer duration of the parting with liquidity that is involved.
In addition the higher interest rate is acompanied by a lower asking price for the bond. Hence there is   a greater potential capital gain if interest rates fall.

The yield curve quite simply depicts the different rates the same borrower is able to borrow at for different periods of time. Typically for the Government this ranges from short term 90 day Treasury bills, to one year bonds to five and ten year bonds. Normally the curve rise from the short to the long. When it inverts the long term interest rate and the overall yield curve flattens out.

This typically means that the financial market understands that the central bank is tightening the supply of credit to slow down economic growth and raise unemployment. The market then expects a slowdown or recession. Usually the inverted yield curve accurately predicts a recession in the coming months.in fact, in the last four recessions there was an inverted yield curve prior to the recession.

Some economists and forecasters in the US, notably James Smith at the University of North Carolina (See Bloomberg news January 2, 2006) is predicting a recession because the interest rate yield curve has inverted in the US.He argues that the US Fed has now overdone interest rate rises because core inflation is quite low, inflationary expectations are under control and the US Fed has raised interest rates 13 times from 1 % to 4.25 % over the past year and a half.

I think that the same situation of an inverted yield curve and impending slowdown may well prevail here in Canada if the Bank of Canada doesn`t get its heavy   foot off the brake and stop raising the rates here.