Thursday, December 02, 2004

The Yield Curve, Part III

Now that we know what an effective tool the yield curve can be let's take a look at what it is saying now.


Click to Enlarge Posted by Hello

Using the academic study we looked at in Part II of this series, we can see that there is a less than 5% chance that a recession is 4 quarters away. Remember, the study took the 10-year T-Bill rate and subtracted that by the 3-month T-Bill rate. Using that simple equation we get a yield spread of 2.32 (4.40-2.08) at the time of writing.

So, currently we are out of the recession woods.

Here is one soothsayer's take on the present condition of the yield curve. For a few weeks long-term rates stubbornly stood at low levels, flattening the curve a bit and forecasting a slow down in the economy. With the complexities of the falling dollar spurring foreign business for US international businesses, long-term bond rates have started to climb to slow the inflation and attract more foreign money.

Speculations abound that China is no longer buying US bonds with their profits from large export trade to the US. They may be buying EUROBonds. No one knows for sure, but the yield curve is starting to steepen again. If the long bond rates can climb as fast as the short-term bill rates, this economy will pick up steam into next year. However, when you see a flattening or inverted yield curve, you must stand ready to exit your long equity positions.

If the long rates (10-year) stay at current levels and the short rates (3-month) increase, a flattening of the curve will occur that will slowly crunch the economy. If long rates increase proportionately with short rates, that may kill the economy even quicker. If that happens, the housing sector, copper, lumber, concrete, furniture, and mortgage companies, etc. will get creamed. There will be enormous efforts to keep this from happening by foreign countries and the Feds.

The problem that nobody seems to want to talk about is the buying by the Fed to keep the long bond's rate artificially high will have to be done with newly printed money. This new found money will keep inflating the economy to unsustainable levels. That is not good; be watchful and ready, dear reader.

I'd also like to point out another amazing tool at stockcharts.com. They have a dynamic yield curve presentation where you can actually watch what the yield curve was doing from 1997-present and what effect that was having on the stock prices. Play around with it. It's really interesting and telling.

I hope you enjoyed my reports on the yield curve, and hopefully you learned something.

Best Regards,

The Soothsayer of Omaha


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