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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Disguised 'conundrum'


Head-scratching over whether this week's U.S. yield-curve inversion is a true bellwether of recession is merely a new spin on a hoary old problem that has puzzled economists all year.

Rather than some ill omen, the inversion -- an unusual rise in two-year borrowing rates above 10-year rates -- has occurred because long-term rates have remained stubbornly low or fallen as the Federal Reserve has jacked up short-term rates.

While economists have a plethora of theories, few still have a watertight explanation for why 10-year borrowing costs are lower now than when the Fed began a campaign that has more than quadrupled short-term interest rates.

It is this "conundrum" -- the term Fed chief Alan Greenspan coined for the puzzle back in February -- that lies at the root of the U.S. economy's remarkable resilience this year.

Until it is better understood, many economists believe that trying to read the tea leaves of this week's peculiar bond market configuration is a wasted effort.

"Mr. Greenspan's 'conundrum' is a central issue here and asks whether the yield curve today means what it used to mean," said Anirvan Banerji, director of research at forecasting firm Economic Cycle Research Institute. "Even if it does mean what it used to, the record is still pretty patchy anyway."...

ECRI, which claims to have been one of the few forecasters to flag an impending downturn early in 2001, said its leading indicators predict an acceleration in the manufacturing sector in the next few months and only some aggregate slowdown late in 2006.

"The outlook for the second half is shakier -- but we do not see any sign of recession here," said Banerji.

But whether the yield curve predicts recession or not, most economists say it is still critical to heed signals from the bond market...