Planet Yelnick

Do Not Cry Wolf! Wolf! Over Flat Yield Curve

The yield curve is almost flat.  The spread of 3.3% between the 3-month note and the 10-year bill has dwindled to 0.5%, and should soon flatten.  In five of the last seven times this occurred, a recession followed.  Goldman Sachs looked at this today and concluded that this time a flat or even inverted yield curve is unlikely to presage a recession.   Their arguments: 

1. Based on history, a modest inversion is not enough; the inversion needs to exceed a 1.2% negative spread (long lower than short).
2. The inversion typically occurred after the Fed had raised short term rates too much, and was about to lower them; whereas in this case the Fed is more likely to stop the rate increases but not turn around and drop rates.
3. The cause of the recession was often a drop in bank credit due to higher cost of borrowing, but since the last inversion, bank credit has become less important than capital market credit (via securitization of debt).
4. This time around the depressing of long term rates (Greenspan's Conundrum) has not been slack demand domestically for investment capital, but excessive demand for Dollars as a reserve currency due to globalization.

In other words, as long as the Chinese et al. need to recirculate their Dollar holdings, the long-bond will have modest yields.  That is likely to continue through the 2008 Olympics - the Chinese equivalent to our Y2K spending spree.  They will spend what they have to to make that a success, then all bets are off on continued spending in 2009.

If Goldman is correct, 2006 should see a slackening of US growth but not a recession, and a modest stock market correction not the Big One down.  That will be postponed until after the 2008 Olympics.

The Markets, The Rates and The Wave Count

Let me sort out where we seem to be across various markets.  Bottom line is not to expect any fireworks yet, up or down; we are in a seasonally bullish period, and it should continue (with a small drop along the way) into January, and more likely into a topping period from March - May 2006.  Then we enter the downward pressure of the four-year cycle, into late 2006 or early 2007, before the normal interference of the government into the economy pumps us upwards through the 2008 election.  This is pretty much the scenario that has been laid out in recent posts, and tracks a longer term prediction repeated over the past several years.  If we don't have a hard drop into late 2006, I will have to change my views on this market.