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Yield Curve Scares Economists

On Tuesday, the placid post-Christmas markets were rattled by news that interest rates on two-year bonds nudged higher than those for 10-year bonds. This was the dreaded inversion of the yield curve, and it sent the markets running. Why? Traditionally, inverted yield curves signal bad news for the economy--and hence for stocks. As the highly reliable Paul Kasriel of Northern Trust, quoted in yesterday's Wall Street Journal, put it, "this is a warning signal ... that we are on recession watch now."

Recession watch? You don't have to be a jolly optimist to believe that was an overreaction. Indeed, the concern about momentary inversion of the yield curve--it has since un-inverted--is a lesson in how Wall Street can be constrained by rigid thinking.

Market analysts, economists, and traders are schooled to regard certain bromides as verities. Stocks rise in January, bad things happen in October, etc. Two of these bromides are A) rising interest rates and higher energy prices are poison for the economy, and B) an inverted yield curve signals recession. The former was disproved in 2005. Short-term interest rates rose sharply as the Federal Reserve continued to hike rates at every opportunity it had, and energy prices continued to climb. Yet the economy grew at a healthy clip.

And the inversion thesis will likely be disproved in 2006. Just because a portion of the yield curve inverts, it doesn't mean the economy is poised to make like the S.S. Poseidon. In theory, an inverted yield curve means that investors and the Federal Reserve are fretting about inflation in the short term, and that investors are pessimistic about long-term growth. The combination of slow growth and high inflation is often deadly. But there's ample reason not to freak. Most academics downplay the two-year bond and instead look at the spread between three-month Treasury bills and 10-year bonds, notes Lakshman Achuthan, managing director at the Economic Cycle Research Institute, one of the few outfits to accurately forecast the 2001 recession. That three-month/10-year curve hasn't inverted. What's more, while the last four recessions were preceded by an inversion of the two-year/10-year yield curve, "it gave a false alarm in 1998," Achuthan notes. "So one quarter of the time it's been wrong."

More broadly, he notes, it's folly to point to a single indicator, or even to two or three indicators, as ushering in a recession--even if they're very visible ones such as interest rates, energy costs, and inverted yield curves. Lots of other things also have to be moving in the wrong direction at the same time. "You have to look at a broad array of leading indicators and see if there's a consensus," he said. And the consensus--among economists and among leading indicators--doesn't signal that anything close to a recession is in the offing.

As a group, for example, the 56 economists polled by the Wall Street Journal in November believe growth will average 3.2 percent over the course of next year. That's a slowdown from the current rate of growth but nowhere near a recession. (Here's the data from the survey.) Not a single economist of the group forecasts negative growth for any quarter.

Of course, economists, like wildebeests, tend to move in herds. And they generally tend to forecast continuation of existing trends. Very few of them saw the 2001 recession coming. But less emotional and fallible predictors agree with them. The Leading Economic Indicators, compiled and issued by the Conference Board, foresees a slowdown in the rate of growth, but nothing like a recession. ECRI's Weekly Leading Index, which comes out with greater frequency than the LEI and hence is more sensitive to shifts in the direction of the economy, is emitting similar nonrecessionary signals.

Achuthan does believe economic forecasters are too optimistic. "The lesson learned from 2005 when they were prematurely pessimistic is that this economy can handle all kinds of grief, and still pump out 3.8 percent to 4.0 percent growth." But 2006 will be different from 2005. The services and construction sector of the economy will slow down noticeably. With signs of a possible slowdown in the housing market, consumers won't be able to increase spending aggressively. But ECRI's indicators also show that the industrial and manufacturing sectors will thrive.

While the economy presents us with plenty of worries as the new year dawns, a recession probably isn't one of them. So, why are we seeing this seemingly promiscuous use of the R-word? Part of the problem is that economists today have the same issue with recessions that weathermen in Florida have with snowstorms. One of the amazing developments over the past quarter-century has been the declining frequency of recessions. In the past 23 years, there have been only two brief recessions. Economists just don't see recessions enough to know when one is really coming.