If you're feeling a warm glow of satisfaction while looking at the economic indicators coming out of the United States, it might be that extra glass of eggnog you had at the office party (spiked, as usual, by Norm from accounting), or it might be the fact that things are actually looking pretty good right now. Not great — because that would raise the spectre of inflation, and therefore the risk of higher interest rates — but not bad. Just bad enough to be good, in that twisted sort of way that seems to make sense only to economists.
Pick just about any number and you can probably find a rosy side to it. Take U.S. inflation, for example: It fell faster in November than it has in more than half a century. But isn't that a sign of a slowing economy? Well, no. It's a sign that gasoline prices came down faster than they have in decades, and pulled inflation down with them. Core inflation came in 0.2 per cent higher, which is right where most economists expected it to be. And that's a "Goldilocks" number: High enough to show strength, but not high enough to show that inflation is getting out of control.
Unfortunately, some economists say there is a potential Grinch on the horizon, one whose sleigh is aimed straight at the heart of Whoville — a Grinch called the "inverted yield curve" (okay, it's not really a Dr. Seuss kind of name, but stay with me). Just as the Grinch snuck in to the little Who village disguised as Saint Nick and snatched all the toys away, some market analysts say there is a risk that the inverted yield curve could spell trouble for the U.S. economy, and as a result, for the Canadian economy as well.
Try and stay awake for this part, because it's important. The term "inverted yield curve" describes a situation in which the yield (or return) on short-term bonds has risen above the yield on longer-term bonds. That's the reverse of the usual state of affairs in the bond market, which explains the term "inversion."
This phenomenon occurs when investors agree to pay more for long-term bonds than short-term ones (an increase in the price of a bond means a reduction in yield). And why would they do that? Because they believe that short-term bonds are riskier. In other words, they believe the economy is in for a short-term shock of some kind, such as a recession or similar downturn.
Quick translation: An inverted yield curve is bad. Every recession the United States has experienced in the past 50 years was preceded by an inverted yield curve. Is there such a curve now? No. But it's getting close — at one point yesterday, the yield on a five-year note fell below that of a two-year note, which constitutes an inversion (although the yield on longer bonds remained higher). Economists say the entire curve could be inverted by early in 2006, if the Federal Reserve Board sticks to its guns and raises the benchmark lending rate again in January of next year, as most observers say it is likely to.
Not everyone believes in the yield-curve Grinch, mind you. Among the skeptics is a guy named Alan Greenspan, who is just a month or so away from stepping down as chairman of the Federal Reserve. Mr. Greenspan — who has expressed surprise at how long-term yields have remained low despite increasing short-term interest rates — has suggested that an inverted yield curve isn't quite as dangerous an indicator as it was in the past, as a result of changes in the economy and in global financial markets.
The Fed chairman and others — including St. Louis Fed president William Poole — have said that low long-term yields may reflect the fact that long bonds are seen as lower risk than they were in the past. Of course, many economists dismissed the inverted curve in 2000, just before the U.S. economy went in the tank. And the Federal Reserve Bank of New York said in October that its research shows the "forecasting power of the yield curve" is very much in force.
A report released yesterday by TD Bank said there is some reason to believe that the current yield curve is not a flashing hazard light for the economy. For example, the bank says that in most cases leading up to a recession, interest rates have been much higher than they are now. And TD's economists say that even if there is a slowdown, they don't believe it will be a "hard landing."
In other words, maybe the Grinch will turn over a new leaf — like he does in the book — and bring all the presents back to Whoville.
Mathew Ingram is the Globe and Mail's on-line business columnist. Feel free to post a comment or e-mail Mathew at mingram@globeandmail.ca
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