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A warning warning reverses, but the damage can be done



The Wall Street message is clear: The US economy is not in the kind of trouble investors feared earlier this year.

The stocks are high and climbing at all times. The return on long-term government bonds, which reflects expectations of growth and inflation, is also rising. Property bond spreads show that investors are more confident about the outlook for businesses.

Then there is the yield curve, an indicator from the bond market that only a few months ago raised alarms about the risk of a recession. It has returned to normal, and that signal has been met with relief in the markets.

But for the economy it may not be important. When the yield curve has predicted a recession, one usually follows even if that signal changes la ter.

To understand why, it is important to remember what the baskets of the yield curve acted in the first place.

The yield curve measures the difference between interest rates on short-term government bonds and long-term government bonds (such as three-month government bonds and 10-year government bonds).

Usually, long-term interest rates are higher because the government, like any borrower, should pay more to borrow for 10 years than for three months. But sometimes things are turning around in the bond market and short-term interest rates are rising over the long term, signaling that investors expect slower economic growth or interest rate cuts – or both.

When it does, the yield curve becomes what economists call "the reverse." It happened this year, and started in March, and it gained attention because a reverse yield curve is considered one of the world's most reliable predictors of a recession.

In fact, every recession in the last 60 years was given an inversion of the yield curve.

Those who have studied the yield curve and its relationship with the economy emphasize that historically it does not matter if the yield curve returns to normal. The recession is like the other way around – although the decline can take as long as two years to arrive.

"In a way, the damage has been done," said Campbell Harvey, a Duke University finance professor, whose research first showed the predictive power of the yield curve in the mid-1980s. "If you look at the track record, if you've got an inversion, there's a recession that follows."

One reason is that the yield curve has a real impact on the banking system. Banks lend money at short-term interest rates and then lend them – in a 30-year mortgage, for example – at long-term interest rates.

So when short-term interest rates are higher than long-term interest rates, bank profits are crushed and they cut down on loans. This is bad news for the economy.

Then there is the feedback loop on the market, which can make managers' decisions difficult and discourage new investments.

"When the yield curve is reversed, investors are pulling in risk-taking," Golub said of Credit Suisse.

Mr. However, Harvey emphasized that history did not always repeat itself accurately.

And this time is something a little different. Since the yield curve was reversed, the Fed's three interest rate cuts have largely been seen as effective ways to keep the economic expansion going.

The first of them, in July, came just a few months after the yield curve first inverted.

That's a marked difference from the last time the yield curve reversed, in 2006. It was then about a full year before the Fed began lowering short-term interest rates. (The last recession began in December 2007.)

"In the face of the inversion, it did nothing," Harvey said, referring to the Fed. "They actually cut this inversion."


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