First it was an issue of whether the yield-curves would invert. Now its a question of how much they invert. Is this the end of the era of cheap money?
Regardless, here is a good article that explains the issues involved with bonds in plain english. Worth a read.
Yields on Bonds Invert, Reflecting
Unease About Economy's Future
December 28, 2005
The nation's bond market interrupted the holiday season with a downbeat message yesterday: Many investors expect the economy to hit tougher times within the next year or so.
That pronouncement came in the form of long-term interest rates dropping below short-term rates, a trend that often -- but not always -- precedes an economic downturn. The development is known as an inversion, because it flips the traditionally upward-sloping shape of bond yields plotted on a graph. The yield curve typically rises because longer-term debt usually pays higher interest rates to compensate investors for the greater risk they incur waiting for repayment.
Inversions can squeeze or even eliminate profit margins for banks, hedge funds and any other financial business that borrows money at short-term rates and lends it at long-term rates. "This is a warning signal...that we are on recession watch now," says Paul Kasriel, chief economist at Northern Trust Co. in Chicago. The inversion, however, so far is minor, he says. And some economists believe an inversion isn't as reliable a predictor as it once was.
Bonds make fixed interest and principal payments to investors, but their yield depends on what the market is willing to pay for the bonds on any given day. In deciding what yield -- or return -- to demand on bonds, investors consider various factors, including their expectations for future short-term interest rates and the bond's duration.
Investors, for example, usually demand more yield from governments and companies to tie up their money in longer-term bonds. When they are willing to accept a lower yield, that means they are persuaded that the Fed, which most expect to raise short-term rates to 4.5% or higher early next year, will soon have to bring those rates back down to mitigate, or ward off, a recession. Yield-curve inversions have preceded all of the last six recessions, but have also sounded two false alarms, the most recent in 1998.
The housing market is the most likely trigger for an economic slowdown and Fed reversal. As the Fed raises rates, monthly payments on adjustable-rate home loans go up, cooling demand for houses and leaving homeowners with less money to spend on all the other things companies want to sell them. Second, as house prices stall, homeowners aren't able to borrow as much against the value of their homes -- a source of cash that has added hundreds of billions of dollars to consumers' spending power in recent years.
"What the Fed is going to do is shut down the ATM machine known as the housing market," says Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles.
