Do You Believe The Yield Curve?

The above graph shows the spread between the 10-year Treasury Bond and 3-month T-Bills. It is basically a numerical representation of the yield curve, showing the severity (or lack thereof) of the slope of the curve.

The slope of the yield curve is often looked at as a forward indicator of the economy. It generally has a lag-time of about a year. Thus, when the yield curve inverts, and has a negative slope (short-term rates higher than long-term rates) it is a sign that the economy could weaken over the next 12 months. At its extreme, it forecasts recession.

The last time the yield curve inverted was the year 2000. But with the stock market booming, most investors ignored the signal. But by 2001, a recession did come. I know there were other circumstances, but the signal was still validated.

More recently, the yield curve inverted last summer of last year, 2007. Again, most investors brushed off the signal, as the credit crunch seemed to be exacerbating the yield curve and putting downward pressure on long-term yields. Remember the "conundrum"?

Also, there were a lot of people that I speak with who were of the opinion that the bond market was just trying to send a message to the Fed that they were too tight with monetary policy, and that the inversion of the curve would only be temporary.

Well lo and behold, here we are a little more than a year later and every economist I know of is talking about recession. Go figure. But what is the yield curve saying now?

The yield curve has returned to a very positive slope, as T-bill rates have come way down. If you subscribe to the forecasting power of the yield curve, then you have to conclude that the yield curve is predicting a much strong economy next year.

So do you believe the yield curve? Or are you dismissing it the same way investors did in 2000 and 2007?