Are we moving slowly but inexorably to a full inversion of the US yield curve?

THE SHORT VIEW
By Philip Coggan Copyright by the Financial Times
Published: February 2 2006 02:00 | Last updated: February 2 2006 02:00

Are we moving slowly but inexorably to a full inversion of the US yield curve? The market's interpretation of Tuesday's Federal Reserve statement was that a further quarter-point increase in the Fed Funds rate in March was more likely than not.

That would take the Fed funds rate to 4.75 per cent, compared with Tuesday's closing Treasury bond rates of 4.54 per cent on the two-year issue and 4.55 per cent on the 10-year. There was a brief inversion at the end of 2005 when two-year yields were higher than those on 10 years. But some analysts say an inversion is only significant if the three-month Treasury bill rate is higher than the 10-year yield; that has yet to happen.

However, unless the Treasury bond market suffers a significant setback in the next six weeks it is hard to see inversion being avoided if the Fed does raise rates in March.

The state of the curve already raises interesting questions for investors. If you are prepared to take the small risk of a leading bank failing within the next three months, dollar Libor earns 4.68 per cent.

Clearly, the yield on the two-year Treasury bond encompasses the expectation that the Fed, under new chairman Ben Bernanke, will have to start easing monetary policy again, either this year or in 2007. To that extent, the flat yield curve suggests investors are forecasting an economic slowdown, if not a recession.

But what is the 10-year rate telling us? It may be that there is a glut of savings in Asia, although that continent's central banks tend to own bonds at the shorter end of the curve. Or it may be that investors' confidence in the stability of economic growth and inflation means the Treasury no longer needs to pay a "term premium" for borrowing over long periods.

Such confidence would explain the buoyancy of the equity market. Investors seem to feel there has been an improvement in the trade-off between growth and inflation that is good for equities and bonds.

However, what does not fit is the continued surge in the gold price. Is gold simply being driven by speculative enthusiasm or is it telling us something that equity and bonds investors are ignoring?