Investor's Business Daily
Dread The Spread
Tuesday February 15, 7:00 pm ET
Ibd
Fed Policy: The spread between long- and short-term interest rates -- the yield curve -- is one of the best forecasting tools available. As such, you may be interested to know what it's saying right now. It isn't good.
When Fed Chairman Alan Greenspan delivers his semiannual economic outlook to Congress Wednesday, he's expected to talk about the dollar, jobs, trade, inflation, debt and savings, among the many other things he keenly follows.
Well, we hope he doesn't leave out the yield curve.
In brief, the yield curve shows how short-term interest rates compare to long-term rates. Normally, it slopes gently upward, with short-term rates well below long-term ones.
But when the curve flip-flops -- or "inverts," in economics lingo -- watch out. It usually means the Fed, which controls only short-term interest rates, is slamming on the brakes.
Every recession since 1960 has been preceded by an inverted yield curve. Only once -- in 1966, when the economy scraped the runway but didn't crash-land -- did an inverted curve fail to predict a slump.
Today, one widely followed measure of the yield curve is coming perilously close to going negative (see chart). That means slower growth ahead.
That's not just a guess. A number of recent studies have confirmed the yield curve's uncanny ability to predict economic trends.
If so, the Fed should watch its step. Bond market observers have watched in amazement as yields on long-term bonds have continued to fall to near 4%. Meanwhile, the Fed -- with Greenspan leading the way -- has raised short-term rates six times since June.
They now stand at 2.5%. If the tightening continues even at a "measured" quarter-point pace, they'll be just below 4% by summer's end. That may be enough to send short-term rates crashing through long-term rates, the equivalent of shoving the economy into an anti-inflationary, anti-growth ice bath.
Some Wall Street commentators suggest this time is different. Interest rates and inflation are so low overall, they explain, that any rises in short-term rates are likely to have minimal impact.
But interest rates are a relative thing. If the Fed continues to hike rates as it has since last June, short-term rates will soon be nearly three times their year-ago level. In relative terms, that's a big hike -- one that could send the recovering stock market, housing and retail sales reeling.
Chairman Greenspan, watch out! Your last month in office is January 2006. It would be too bad if your legacy was handing your successor an economy in recession
