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World Isn't Flat, but Yield Curve?

In late December, interest rates on two-year Treasury notes rose higher than rates on 10-year notes.

This yield curve inversion, as the phenomenon is known, sent the stock market into a brief tailspin and inspired a round of intense chin-tugging among economic analysts. After all, inverted yield curves have generally been viewed as the black cats of the economy, heralding slowdowns at best and recessions at worst.

Still, many economists urged investors to ignore the ill omen because of the uniqueness of the United States economy and the role it plays in the global economy.

Alan Greenspan, the departing Federal Reserve chairman, has labeled the persistence of very low long-term interest rates in the face of solid growth and rising short-term rates as "the conundrum." It is generally agreed that the conundrum can be explained by a combination of factors that keep a lid on long-term rates: an exceptionally flexible and resilient economy, a huge trade deficit that spurs heavy purchases of long-term government bonds by foreign investors, particularly Asian central banks, and the inflation-fighting credibility of the Federal Reserve...

What gives?

"The conundrum is global," said Lakshman Achuthan, managing director at the Economic Cycle Research Institute, based in New York. The same factors that are influencing the interest rate climate in the United States are having similar effects on overseas bond markets...

There has also been some convergence in the mentality of the large economies' central banks, which directly control short-term rates and indirectly influence long-term rates by signaling their willingness to fight inflation. "Long-term inflation expectations have been pushed down around the globe, because investors believe the central banks are on the watch against inflation," Mr. Achuthan said.

He warns that we shouldn't read too much into the shape of yield curves. After all, he notes, since World War II, flattenings of yield curves, as measured by the difference between rates on 3-month and 10-year government debt in the five largest economies - the United States, Japan, Germany, Britain and France - have issued false alarms of recession 38 percent of the time.

Flattening curves have done a better job of indicating slowdowns - declines in the rate of expansion. They presaged slowdowns 94 percent of the time in the United States and 66 percent of the time in Japan...