Inverted Yield Curve: Recession Approaching?

The December 26th issue of Fortune magazine discussed the inverted yield curve that seems to be rapidly approaching. I cut out a page from the article in December, and meant to post it online. Currently, the yield curve is flat, and but if rates continue rising, it won't stay flat for long. More from Fortune magazine on why you should care about inverted yield curves…

The economic landscape includes an energy shock, a cooling housing market, rising inflation, and Federal Reserve rate hikes. All of these are classic warning signs or symptoms of an economic slowdown–something to keep in mind as you're deciding where to invest in 2006. Rising interest rates, for example, are a big drag on consumer spending. Higher rates mean heftier credit card bills and far fewer opportunities for the cash-out mortgage refinancings that have been putting nearly $60 billion a quarter into the hands of consumers.

"That's 2% of GDP, and it goes a long way toward explaining how the consumer has managed to keep things together in the face of punishing energy prices," says Merrill Lynch chief economist David Rosenberg. Just as ominous as the overall rise in interest rates is the relationship between long and short-term bond yields.

So, What the Heck is an Inverted Yield Curve?

An inverted yield curve occurs when short-term rates exceed long-term rates. For example, an inverted yield curve will occur when the 3 month Treasury bill yield (the short term rate) exceeds the 30-year Treasury bond rate (the long-term rate). Find out more about the effects of an inverted yield curve.

Why Should I Care?

Inverted yield curves predict recessions with frightening accuracy. According to a New York Federal Reserve study, every time the U.S. has had a period of inverted yield curves, recession followed within a year.

The danger signals are so unmistakable that J.P. Morgan Chase market strategist Abhijit Chakrabortti believes Wall Street's bulls are in denial. "I'm thinking of calling my year-end report 'Eyes Wide Shut,' " he says.