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"However, this evidence does not necessarily imply that the predictive power of the yield curve has disappeared altogether, only that the values of the parameters in the formal models may have changed. Models of a more qualitative nature, such as those that predict recessions, seem to be affected much less or not at all, as documented by Estrella, Rodrigues and Schich (2003). Theory suggests (e.g., Estrella (2005a)) that there is a persistent predictive relationship between term spreads and future real output, though the precise parameters may change over time.

"Since yield curve inversions and economic recessions correspond to extreme values of those variables, a connection between inversions and recessions may be systematically detectable even if parameters change over time within reasonable bounds.

Thus, although yield curve inversions may not be followed by recessions as a matter of universal mathematical principle, they should definitely raise warning flags about future output growth."

Let's draw this article to a close with a few observations. Even if the yield curve does fully invert, it suggests that we will not see an outright recession in 2006? Why? Because to get a 90 day average negative number is going to take close to 90 days. If we get there, a recession is still at least 3-4 quarters away.

That does not mean we could not see the beginnings of a slowdown. In fact, if we do see an inversion, it would suggest a slowdown in the latter part of 2006 is likely. Remember, we never go directly to a recession from a strong economy like we have today. It takes time to slow an economy down.

Secondly, the stock market drops an average of 43% before and during a recession. That is an ugly number. But it is a very real number. And you do NOT want to wait until the last moment to head for the sidelines. Much of the drop in the market will happen prior to a recession, and we only know if there was a recession in hindsight. Usually, by the time we find we are in a recession, it is time to start buying.

Third, there are going to be a lot of people arguing that this time it's different if we do get a full blown inversion. And to be perfectly candid with you, it may be. I will go over that rationale in some future article. But I will tell you this, I highly doubt I will buy it. When you have something as reliable as the yield curve telling you there are problems in Dodge City, it may be time to think about leaving town. Perhaps new sheriff Ben Bernanke can solve the problem before it emerges. But I am not sure I want to bet my portfolio on his ability.

Is it time to head for the hills yet on your index funds? Not really. The yield curve is not really telling us anything other than to pay attention at this time. So we will. I should note that many indices other than the internet bubble NASDAQ were not that far from their highs in July of 2000 when the yield curve started to show serious problems. In fact, the markets went up for a month or so following that negative inversion.