- The Washington Times - Wednesday, May 11, 2005

Let’s continue discussing last week’s topic — the inverted yield curve. For the folks who missed it,

“inverted yield curve” is the term used when the rates on short-term loans exceed the rates on long-term loans.

For example, an inverted yield curve would occur when the yield on a one-year Treasury bill is higher than that on a 10-year Treasury bill.

Logically, such a scenario shouldn’t happen. Lenders normally demand a higher return on their money if they are going to guarantee a particular interest rate for a longer time because their money is tied up longer.

I did some poking around on the Internet and found some interesting historical data. In March 1989, the average yield on the one-year Treasury bill increased to 9.57 percent. During the same month, the yield on the 10-year note was hovering around 9.36 percent.

For the folks who are old enough to remember, 1989 was near the beginning of a recession. The Washington housing boom faltered, and real estate prices dropped in many areas. Home values remained fairly flat for years to come.

Then, in 2000, after a brisk refinancing market thanks to low mortgage rates, Fed Reserve Board Chairman Alan Greenspan became worried about inflation and began a series of short-term interest-rate increases. During most of 2000, yields on short-term securities exceeded those on longer maturities.

The result? Mr. Greenspan indeed may have staved off potentially harmful inflation, but not without cost. The housing market slowed, new construction faltered, and mortgage companies and title agents were busy twiddling their thumbs.

After both of these periods of an inverted yield curve came a recession, by most economic definitions.

How does this relate to the economy today? Well, I’m certainly not predicting that a recession or even an inverted yield curve is on the horizon, but the spread between short-term and long-term rates continues to flatten.

Last week, the Fed bumped up the federal funds rate, a short-term rate, by a quarter-point once again. Long-term rates dropped slightly on the news.

Remember that short-term rates are largely governed by the Fed, while long-term rates are market-driven.

Let’s fast-forward to recent data. As of the end of April, the average yield on the one-year Treasury bill was hovering at about 3.34 percent. The 10-year note was yielding about 4.20 percent. We’re less than 1 percentage point away from a flat yield curve.

Most, if not all, economic gurus had predicted that long-term rates would be much higher in 2005. We’re not there yet.

If market demand for long-term notes continues to be strong while the Fed continues to raise short-term rates, don’t be surprised if the yield curve flips.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@pmcmortgage.com).

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