The bond market’s crystal ball

It is often thought that, when borrowing money for a shorter period of time, the risk to the lender is less; therefore, so, too, should be the “cost” of short-term capital. Most times, this is indeed the case, but occasionally, the bond yields associated with short-term instruments exceed that of long-term yields—the so-called “yield inversion.” Bankers and economists have noted that these periods tend to precede recessions, and because of this, journalists have made much of the predictive power of the yield inversion.

Because the spread between long-term and short-term interest rates has been virtually nil for much of the first quarter, the bond market is suddenly garnering a lot of interest. A yield inversion has occurred roughly one to two years prior to each of the last six recessions in the United States, and although the bond market has flirted with such an inversion for the last four months, an absolute inversion has not occurred (but we are close).

These inversions tend to last the better part of a year, and the inversion that preceded the Reagan administration lasted well beyond that duration. In other words, the inversions coming before recessions tend to be fairly prolonged ones. As The Economist pointed out in January, the only fully inverted curve to “cry wolf” and not precede a recession occurred in 1966—the inversion was short-lived and, like today, the reason for the inversion was the abnormally low long-term interest rates (rather than high short-term rates). So there seems to be more than enough fodder for both optimists and pessimists in the latest interest-rate data.

Further complicating matters, not all analysts are convinced of the yield curve’s predictive power across the board. A recent article from the Federal Deposit Insurance Corporation (FDIC) has noted that the stubbornly low long-term rates have remained low despite the Federal Reserve’s gradual increase in the federal funds rate over the past two years. Historically, these rates have moved in sympathy with one another. The FDIC posits four possible explanations for the low long-term rates. First, there is a low term premium at work, resulting from increased stability in the global financial markets and the use of newer financial instruments, such as derivatives, that many feel reduce long-term risks. Second, inflation worries are still relatively low, thereby obviating the need of the Federal Reserve to create a self-induced recession to control prices. Third, foreign central banks are still buying American debt at quite a brisk pace, serving as a ready market for US debt and pushing down long-term yields. And last, the FDIC article suggests that the investments from hedge funds and pension funds could depress the long-term rates as well.

Yesterday, Fed Chairman Ben Bernanke addressed the Economic Club of New York on this topic and chose his words with characteristic caution, ultimately concluding that the cumulative evidence from the bond market is “ambiguous,” mostly due to macroeconomic factors occurring outside of the United States that are clouding the bond market’s crystal ball.

The 2008 presidential election cycle might seem far off, but the recent strange behavior of long-term interest rates could have a huge role to play in determining how the election proceeds. If (and it’s still a big if) we should see a true yield-curve inversion in the second quarter of this year—and if it is sustained for the better part of 2006—chances are high that the 2008 presidential campaign will occur smack in the middle of a recession. Or depending upon the timing, the new administration will be immediately greeted post-election with bad news on the economy, much as the Bush Administration was in 2001. But where the Bush administration had the benefit of surpluses and could run deficits to spur economic expansion, the new administration will not have that luxury after years of excessive public spending. Factor in, as well, that fiscal discipline, for the first time since 1992, will be seen as a top-drawer issue on the 2008 campaign trail, and it may be that the winner in 2008 will wish he’d waited one more cycle to run for office.