The Inverted Yield Curve No Longer Presages Recession

The financial press has been frazzled by the prospect that the private-equity gravy train will eventually run out of gravy, and the risk that the Chinese may curb their purchases of U.S. bonds to get into the private-equity racket.

Consumers are talking a good game while shopping mostly for necessities, not frills. The economy expanded at an annual rate of 0.6% in the first quarter, not nearly fast enough to keep up with population growth. Per capita, we're arguably in a recession already. Given the trends in housing and energy, the summer could prove pretty sticky yet.

But at least we don't have the inverted yield curve to kick around anymore. This usually reliable recession portent was flashing danger signals throughout the recent bull run. But on May 16, the three-month Treasury bill's yield finally dipped below that on the 10-year Treasury note for the first time since August. Buyers were once again insisting on a higher interest rate for debt maturing in a decade over that which will be paid back before Labor Day.

They weren't and still aren't demanding much more interest, mind you, for that considerable commitment stretch. But the fact that the longer-term debt was yielding any premium at all was taken as a welcome sign of normalcy, in a world that's no longer certain what that means from day to day. The Dow Industrials rallied 103 points.

Until then, buyers of long-term bonds had assumed all the risk of higher inflation and interest-rate hikes. For the last 40 years, they've only been willing to do that on the eve of a recession. But lately the low long-term rates have been interpreted mostly as a sign that Asian central banks and OPEC oil barons still have no good alternative to U.S. bonds. Far from serving as an economic warning sign, the inverted curve came to signify the global liquidity wave chasing yields.

All that cash is still around, by the way. Broad money supply measures in the U.S. and Europe are growing at an annual rate above 10%. The Chinese are sitting on $1.2 trillion in official hard-currency reserves and $2 trillion in low-yielding domestic deposits.

Britons are buying Florida properties with yen-denominated loans. I'm harvesting yields from a British bank and a Brazilian utility courtesy of the interest-free balance-transfer game.

The global money press has been working overtime to match the influx of low-paid Asian workers into the global labor pool with a proportional increase in capital. In the meantime, the imbalance has driven up asset prices much faster than pay in the developed world. Inevitably, there are now worries that the money printers have overshot their mark, creating labor shortages and other inflationary telltales. Interest rates have been going up abroad, but hardly at all in Japan, the primary exporter of liquidity, and not much in China, where money is still lent far below easily achievable internal rates of return.

But if liquidity flows unabated, how to account for the recent upward creep in long-term bond yields, other than to conclude that the safe, dull 10-year Treasury can no longer compete with the appeal of the next big leveraged-buyout play? Europe is in the midst of a cyclical revival reinforced by overdue structural reforms. Commodities remain on fire. Emerging markets continue to emerge unscathed from half-hearted attempts to deflate the Chinese bubble.

Despite the daily cold showers from the business press, risk appetite seems to be going up rather than going down. A Reuters writer worried about the inflation threat recently complained that "there is no single world interest rate to adjust accordingly and no one institution to do it." But what's a problem for some can seem a solution to others. The gravy train is propelled by the knowledge that no single rider is strong enough to pull the emergency brake, absent a reacceleration of consumer prices.

That's not necessarily a bad thing. Asset values are supposed to be more volatile than product prices. And monetary officials have no particular gift for divining the "correct" value or the proper rate of change.

Passengers speeding on a train for parts unknown can't be blamed for trying to make out some signposts along the way. But the yield curve doesn't serve that purpose any more. Its flat shape in 2000 presaged a vicious bear market. Its flat shape in 2006 preceded the steadiest rally in the modern era.

Perhaps the only message waiting there is that the Federal Reserve is now approximately as accommodating as the central bankers overseas, taken on the whole. And we likely won't know whether that's good or bad until the yield curve stops resembling a diving board.