Flat or Inverted Yield Curve, and Recession Watch

New York Fed President Timothy Geithner made a comment recently that provides interesting testimony on the extent foreign investment in our bond market has subsidized our long-term interest rates and mortgages:

"China's policy of buying dollar assets to keep its currency tied to the dollar masks US financial-market conditions and heightens the risk of inflation in the US . China's purchases of US dollar assets could spur inflation by putting downward pressure on US interest rates and producing more expansionary financial conditions than fundamentals warrant.”

With the Federal Reserve ratcheting our short term money to higher rates over the past 2 years, the expectation was that we would see the yield curve shift upward, with a generally higher interest rate at all maturities - for the most part. Instead, we have seen downward pressure on the long end of the curve, largely due to the Chinese government, who have bought as much as 28% of our recent treasury auctions (high demand means higher prices, and lower yields or interest rates).

Looking at the yield curve, the left side has risen much faster than the right, now to a point where we are seeing either flat curves or inverted curves from day to day. Some pundits argue that a flat or inverted yield curve signals a recession to follow, as the expectation is that rates will drop, making longer term maturities more valuable, so investors bid the prices up making the yields lower. This dated wisdom discounts the impact of the modern global economy, where as much as 60% of our treasury auctions have involved foreign money.

With the Fed expected to raise rates 2 or 3 more times, you can count on this curve seeing a steeper inversion, unless the long-term rates start to really lift. We are already seeing foreign interest peel away, as the European Central Bank and the Bank of Japan have initiated tightening cycles in their markets, drawing attention from foreign investors and competition for our money.

This may lift some of that downward pressure on the long side of the curve. On the short side, the Fed will probably have to lower rates again after the full effect of this tightening cycle has been felt. Its kind of like when you get into a hot car and turn on the air conditioner at full strength; after a few minutes you are cold again, and have to adjust the air back to a balanced and comfortable level. The Fed will do this as soon as they find that counter-inflationary sweet spot. And from there, the yield curve will likely shake its way out to a more natural slope.