Rate inversion stirs worries of analysts and investors

~ Last month, long-term interest rates went lower than short-term rates for the first time in five years.

NEW YORK -- Yields on some long-term U.S. Treasury securities have fallen below those on short-term ones for the first time in five years, triggering alarm bells about what that may mean for the economy. But don't expect a quick answer.

If history is any guide, the phenomenon known as the inversion of the yield curve doesn't bode well for what's ahead. When the return on 10-year Treasury notes slid lower than those on two-year notes in the past, it often was a precursor to a recession.

But Federal Reserve chairman Alan Greenspan and many prominent Wall Street economists aren't convinced the yield curve's turn this time will result in such a fate. Maybe, they say, bonds have lost their predictive power.

So the waiting game begins.

Typically, investors demand higher returns on longer-term rather than shorter-term Treasuries to compensate for the risk that inflation will reduce the value of their principal when the securities mature and the government repays them for what amounts to a loan.

But the spread between the two- and 10-year notes has been narrowing for months, and the curve finally inverted in the last week in December, the first time it has done so since 2000 right before the dot-com bubble burst.

Since the inversion, the curve has been largely flat. On Friday, the yield on the 10-year Treasury note was 4.38 percent, just slightly higher than the two-year note's yield of 4.36 percent.

The curve's flattening has come as the Federal Reserve has been boosting short-term interest rates for 18 months to keep the economy and inflation on an even keel. During that time, however, longer-term rates have stayed surprisingly low and the economy has grown at a healthy pace.

That's why the recent inversion has stirred up worries among those who think bad news may be on the way. Merrill Lynch economists looked at the eight Fed tightening cycles over the last three decades, and found in each of the five times that the yield curve inverted, the economy fell into a recession or a deep slowdown.

Looking back at those inversions, the median real gross domestic product, after expanding at an average 4.2 percent rate in the four quarters prior to the inversion, slowed to a 3.7 percent pace in the quarter of the inversion and a 2.3 percent rate in the ensuing four quarters. Today, the median real GDP for the last four quarters was 3.7 percent and analysts expect it to cool in 2006.

"That's a horse with a track record that we would rather not go against," said Merrill's chief North American economist David Rosenberg.

The typical lag between the time of the inversion and an economic recession is 15 months. As Rosenberg points out in a recent note to clients, "Everything the Fed does now, and every basis point the curve inverts today, will likely exert its peak economic impact in early 2007 -- that is where the clouds hover, in our view."

Still, some stock investors chose not to wait, which helps explain why stocks were weak as the inversion happened last week.

Their worries could be unwarranted. While the S&P 500 index has historically topped out three months after the yield curve inverts, the price change for the six and 12 months after the first occurrence of an inversion was a gain of 7.5 percent and 1.4 percent, respectively, according to Standard & Poor's chief investment strategist Sam Stovall.

And while the yield curve has a venerable record as a leading indicator of recession, many economists believe that it might not be an accurate forecaster this go-around.

Among them is Greenspan, who said last spring that should the yield curve become inverted that won't necessarily be a "forward indicator for softening economic activity" as it has been before. "We would not automatically assume that it would mean what it meant in the past," he said.

Positive forces may be keeping long-term rates so low. For one, foreign investors have become big buyers of U.S. government bonds, and that increased demand is depressing yields on longer-term fixed-income securities. There is also a growing need by pension funds for increased investments in longer-term bonds as baby boomers near retirement.

And while it is hard to ignore that the inverted yield curve did accurately predict the last six recessions, there have been false alarms, too, like in 1998 when no recession came despite the curve's moves.

But then again, who knows whether history is the best guide when it comes to the yield curve this time around.

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Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org