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Treasury yield curve inverts again
Yahoo News/FT.com
By Jennifer Hughes in New York
January 17, 2006

Yields on 10-year Treasuries on Tuesday fell below yields on three-month Treasury bills in what is the classic economist definition of an inverted yield curve, triggering more market speculation about the potential for a wider economic slowdown.

The yield curve is a chart plotting the yields of Treasuries of different maturities. It is rare for longer-dated yields to trade below short-term ones since lenders normally demand a higher premium for lending funds for longer periods.

By late trade in New York, three-month paper yielded 4.342 per cent compared with 4.332 per cent on ten-year notes. The curve first inverted in the thin trading over the year-end holidays when two-year yields dropped below 10-year levels, but it unravelled earlier this month.

Inverted yield curves are seen as indicating a slowdown, and possible recession since they reflect market bets that the Federal Reserve will have to lower interest rates to combat any economic weakness.

Since the 1970s, every recession has been preceded by an inverted yield curve, although not every curve inversion has been followed by a recession.

Traders were wary just yet of calling the yield moves the beginning of a prolonged inversion and yesterday were looking to upcoming data and the Federal Reserve's meeting on January 31.

If the Fed, as expected, raises the fed funds target by a quarter-point to 4.5 per cent yields at current levels will be below the target - a rare event that for 10-year yields, has happened only three times in the last 15 years and never more than six months before an interest rate cut.

"If history is any guide, current Treasury yields will be difficult to maintain unless the bond market becomes more confident about the likelihood of an interest rate cut," said Tony Crescenzi, chief bond market strategist at Miller Tabak.

There is however a school of thinking that includes Alan Greenspan, chairman of the Federal Reserve, who believe that this inversion is a false recession indicator, since long-term yields are being held down by heavy investor demand, particularly from pension fund managers, rather than macro-economic bets.

"Then again, we said the same thing in 2000 [the last curve inversion] - that the inversion was the result of scarcity value at the long end of the curve to do with Treasury buybacks," noted Gerald Lucas, trading strategist at Bank of America. "We're going to see slower groth late this year, but the key thing is whether we see a revival after that."

Shortly after the 2000 inversion, the bursting of the dotcom bubble pushed the economy into recession.

An inverted curve almost always means a recesion is on the way.