Inverted Yield Curve

Inverted Yield Curve: Your Investments Are Under Siege

By Dr. Mark Skousen, Chairman, Investment U
Monday, January 2, 2006: Issue #499

While you were away singing Auld Lang Syne, Scrooge made his appearance on Wall Street in the form of the “inverted yield curve,” and the Santa Claus rally fizzled.

So, what is the inverted yield curve, and should you be worried about its investment implications?

If history is any guide, you should be. In the past 50 years, this key indicator has predicted economic recession and a bear market in stocks in all but two cases. And the last time the yield curve inverted was in the year 2000 and you know what happened to the stock market that time. (If you don’t recall, I should let you know that the Dow fell 20% and the Nasdaq 70%.)

The Inverted Yield Curve: a Gem of a Predictive Power?

The yield curve measures the yield on interest-bearing instruments at various dates of maturity, from one day to 30 years. It compares the short-term rate with the long-term rate. For example, look at the following yields at present time:

Three-month Treasury bills are yielding 4%
Two-year notes are yielding 4.3%
10-year notes are yielding 4.3%

The first thing to note from the graph above is that yield curve is not really inverted not yet. It’s more flat than inverted. To really have a negative impact, the short-term rates need to rise sharply compared to the long-term rate, at least by 1-2%. The day the Dow fell 100 points, the yield on the two-year note just barely exceeded the yield on the 10-year note.

In other words, we are not yet suffering from a “tight money” policy, which is what causes a recession and bear market in stocks. To truly suffer from a tight-money policy, the Fed should also be curtailing the growth of the money supply. But right now, M2 and M3 are growing at a 6% rate. That hardly constitutes a tight-money policy.

Where is the Yield Curve Headed?

The more important question is: Will the yield curve become severely inverted?

Right now, the Fed seems determined to raise the Fed Funds Target Rate another quarter-point or two, pushing it up to 5%. That would clearly make the yield curve negative, because with inflation now in check (as measured by the CPI, which includes lower gasoline prices), there is little chance for long-term bonds to decline in price.

In other words, we are likely to see the Fed engineering a genuine inverted yield curve. It’s a bad policy move by Greenspan, who is long in the tooth and fails to see the damage of this artificial policy. Hopefully the next Fed chairman, Ben Bernanke, can do a better job of stabilizing interest rates.

All in all, I suggest you be cautious in the U.S. stock market. I don’t expect to see a bear market along the lines of 2000-03, but it could be another boring year. (The Dow barely budged in 2005.) Better opportunities are available in the foreign markets.

Good trading, AEIOU,

Mark

Today’s Investment U Cribsheet

Don’t forget! On January 17, 2006, Ben Franklin, America’s first financial guru, will be with us on his 300th birthday, answering questions from Investment U subscribers! That’s right - a live chat with Benjamin Franklin. We’ve set up this interview through a brand new technology. While we can’t reveal how it works, we can say that this online event will fill up so stay tuned for details on how to sign up to guarantee your “seat” in the chat room. We’ll also provide a link for you to send your questions for Franklin to our website in advance The interview is exclusive to InvestmentU and absolutely free!
For more on the money supply, see InvestmentU #493, The Federal Reserve Discontinues the M3 Chart: How To Profit from the Fed Ban. I also said today that better opportunities are available outside of the U.S. Be sure to revisit InvestmentU #497, and check out my Stock Market Predictions for 2006: A Huge Bull Market in Foreign Stocks!