US slowdown fears as long-term yields fall

US slowdown fears as long-term yields fall
By Richard Beales in New York
Published: December 27 2005 20:26 | Last updated: December 28 2005 00:01

The possibility of a slowdown in the US economy weighed on stock investors on Tuesday after yields on 10-year US Treasuries fell briefly below those on two-year notes, a rare event that in the past has often heralded a recession.

Yields on 10-year US Treasuries briefly fell below those on two-year notes on Tuesday for the first time in five years – a rare event that in the past has often heralded a recession.

Longer-term Treasury yields are usually higher than shorter-term ones, because of the uncertainties involved in lending at fixed interest rates for long periods.

When the situation reverses, or inverts, it suggests that bond investors expect interest rates to fall, a trend usually associated with weak growth and low inflation.

According to analysts at Bank of America, the past six US recessions have been preceded by an inversion of the yield curve, which plots the yields on Treasury bonds against their maturities. The most recent inversion, in late 2000, came just ahead of the recession that began in March 2001.

Twice in the past 40 years, however, an inversion of the yield curve has not been followed by a recession. This is what Many economists and Alan Greenspan, chairman of the US Federal Reserve, do not think this inversion is the prelude to a significant slowdown – even if it intensifies.

Many observers have suggested economic conditions today are more benign than those surrounding earlier inversions and that, while US economic growth may slow from recent levels, it is unlikely to turn negative.

Alan Ruskin, research director at 4Cast, the economic consultancy, said: “Not many people out there think the economy is going to fall off a cliff.”

Traders also warned against reading too much into market moves, with volume expected to remain light until the new year.

Such activity as there was reflected technical pressures rather than economic fundamentals, as investors closed positions for the year, Mr Ruskin said.

Yields on 10-year Treasuries fell about 1 basis point, or 0.01 percentage point, below two-year yields in early trading. By the end of regular trading, the yield curve had normalised a bit with the 2-year yielding 4.343%, while the 10-year yield stood at 4.349%.

Whatever the growth implications, a period with 10-year yields below two-year returns could affect financial markets because many lenders fund their longer-term lending by borrowing short-term – a strategy that is unprofitable with an inverted yield curve.

After an initial rally, the Dow Jones Industrial Average retreated sharply to close down 1 per cent at 10,777.77. The S&P 500 and the Nasdaq also ended the session off 1 per cent at 1,256.54 and 2,226.89 respectively.

Tuesday’s temporary slight inversion came as analysts were finally anticipating an end to the current Fed tightening cycle, which has seen short-term interest rates rise 13 times since mid-2004 to their current level of 4.25 per cent.

“You have some growth worries, yields come off, and that ameliorates the growth worries in some sense,” said Mr Ruskin.

Fed officials, meanwhile, have argued that investors are now so confident of the Fed’s inflation-fighting abilities that they are demanding a lower long-term risk premium than in the past.

Strong demand for Treasuries from Asian central banks could also help explain why the prices of longer-term Treasuries have remained unexpectedly high and their yields low as the Fed has raised short-term interest rates.

Others have suggested that increasing globalisation has subdued inflation and with it investors’ expectations of future interest rates, making a relatively flat yield curve a less worrying signal than in the past.