At a macro level /need to be mindful of these developments when...

At a macro level /need to be mindful of these developments when thinking about the role of Au [as opposed to fiat money]

Read On -Agent Cooper i just know how you love this brain food over hot croissants and good coffee[ Bar Coluzzi fi] ..Ciao.


World Quakes at 0.004 Percentage Point: Caroline Baum (Correct)

(Corrects spread in seventh paragraph. Commentary. Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)

By Caroline Baum

Dec. 30 (Bloomberg) -- Something momentous happened on Dec. 27, judging from press reports. The yield on the 10-year Treasury note dipped four thousandths of a percentage point (0.004) below the yield on the two-year note.

This inversion between short- and long-term market rates was treated with the same kind of reverence accorded the completion of the human genome project. It merited front-page coverage in Wednesday's Wall Street Journal.

It also came as something of a surprise. The stock market, which presumably had slept through the previous 240 basis points of narrowing in the coupon curve (Treasury bills don't pay a coupon; they're sold at a discount) suddenly recalled that yield curve inversions presage recessions and fell 1 percent, its biggest loss in two months.

The bond market, meanwhile, looked at itself in the mirror, got scared at what it saw and rallied further. ``Yields fell because yields fell'' was the essence of the analysis in the day's bond market stories. Talk about a self-fulfilling prophesy.

It sounds as if it's time to set the record straight on the yield curve. For starters, almost all of the analytical work on the yield curve's predictive powers has been done with the overnight interbank rate, which is set by the Federal Reserve.

``This more pure measure has a nearly perfect prediction pattern dating back to 1966, with leads of 9-20 months,'' writes Mike Englund, chief economist at Action Economics LLC in Boulder, Colorado. The one false signal was in the latter half of 1998.

Accommodation Removed

New York Fed economist Arturo Estrella says the three-month Treasury bill rate compared to the 10-year note yield gives the most accurate signal over long time periods. That spread is currently a positive 30 basis points. Estrella prefers monthly averages, using the Fed's constant maturity series to eliminate the noise. It's the ``persistence of yield curve signals'' that is relevant, he says, not a temporary crossing into negative territory.

There is nothing mystical or magical about a 0.004 percentage point inversion between two-year and 10-year note yields except for bond traders, who often look to profit from relative changes in different maturity securities.

In terms of the yield curve's ability to predict real economic activity, it matters little whether the yield curve has a positive slope of 10 basis points, is perfectly flat or is inverted by 0.004 percentage point. All of those readings suggest monetary policy isn't accommodative.

Binary Signal

How can that be when the level of interest rates is still low?

It's the level of the spread, not the level of interest rates, that describes the stance of Fed policy in any given environment. An overnight rate in and of itself tells us nothing about policy. It's a price. And like all prices, it acquires meaning in comparison to other prices.

In order to keep the funds rate at its desired target, currently 4.25 percent, the Fed provides the reserves the banking system demands: no more, no less. A 1 percent funds rate might not be stimulative -- it wasn't in Japan 10 years ago --if there's no demand for credit (and bank reserves) at that level. The long rate serves as a kind of check and balance on the short rate and Fed policy.

The hoopla over the 0.004 percentage point inversion in the coupon curve makes me wonder where these folks have been for the last 18 months. On June 14, 2004, the spread between the funds rate and the 10-year note yield stood at 387 basis points. One year ago it had slipped below 200 basis points. Six months ago, it was 66 basis points. Today, it's 11 basis points.

Continuum to Inversion

While it's true that inversions have an excellent track record of forecasting recessions -- there's a reason the spread is one of 10 components in the Index of Leading Economic Indicators -- it doesn't mean the shape of the curve should be ignored until the long rate dips below the short rate. The curve emits signals, albeit not recessionary ones, along the way from steep to flat to inverted.

``There is a persistent predictive relationship between term spreads and future real output, though the precise parameters may change over time,'' Estrella says in a series of frequently asked questions (and answers) posted on the New York Fed's Web site.

Despite the intense focus on the implications of an inverted curve, near-term expectations about Fed policy haven't changed one iota. The odds of a 25-basis-point rate increase at the Jan. 31 meeting have been stuck at 90 percent for almost two months. The chances of a March move have been anchored near 60 percent for a month.

Reason to Worry

And no wonder. Fed chief Alan Greenspan is on record as saying the yield curve's ``efficacy as a forecasting tool has diminished very dramatically.'' In written answers to questions posed by the Joint Economic Committee of Congress, Greenspan made an elegant, incomprehensible argument as to why the yield curve sometimes means one thing and at other times means another. This is one of those times it means another, he said.

The economy isn't emitting any contemporaneous distress signals just yet. Yes, housing activity is slowing from its blistering pace. And the consumer may be starting to save more. But vital signs are still strong.

That's the thing about leading indicators, such as the yield curve. Things may be OK now, but it's signaling less robust growth in the future.

If the Fed isn't going to listen to the yield curve -- the next rate increase will push the funds rate decisively over the 10-year note yield -- that's all the more reason why the rest of us should.

To contact the writer of this column:
Caroline Baum in New York at [email protected].

Last Updated: December 30, 2005 11:08 EST