When Is Flat Really Flat?

When Is Flat Really Flat? The bond market is behaving as if the economy is facing future troubles. Amid expectations that economic growth will slow and the Federal Reserve will stop raising the federal funds rate, long-term interest rates dropped below short-term rates. Recently, the yield on a 10-year Treasury note (4.343%) temporarily fell below that of a 2-year Treasury note (4.347%), a rare event. The technical term for this is an "inverted yield curve."

Typically the yield curve is upward sloping with long-term rates higher than short-term rates to compensate investors for the greater risk of inflation they incur while waiting longer periods of time for repayment. From a fundamental and historical perspective, this event has preceded many economic slowdowns and recessions. However, there is a fierce debate currently underway on Wall Street as to whether an inverted yield curve still has predictive powers given changes in the economy and global markets.

According to a 2003 report by the Federal Reserve Bank of San Francisco, each of the last six recessions since 1970 was preceded by an inverted yield curve - an unnerving coincidence. In fact, over the past 50 years an inverted yield curve has only given two false signals. However, the Federal Reserve has publicly discounted the usefulness of the yield curve as an economic indicator this time. Other factors, such as a heavy flow of overseas capital into the U.S. have driven the yield on 10-year notes to abnormally low levels, thus distorting the yield curve's predictive abilities. (Bond prices and yields move in opposite directions.)

It is worth noting that in the past, whenever the yield curve inverted and a recession followed, both short-term rates and long-term rates were on the rise. The difference this time is that short-term interest rates have been climbing gradually while long-term rates have remained relatively unchanged. Considering the federal funds and prime interest rates have risen 2% over the past 12 months, the economy has performed splendidly. It has expanded at better than 3.0% each quarter for the past four quarters, including a 4.1% rise during the 3rd quarter of 2005, with an expected growth rate of more than 4.0% for the fourth quarter. Inflation, including higher energy prices, remains mild and the economy is growing at a surprisingly solid clip.

A concern is that with the recent rise in the federal funds and prime interest rates, businesses at the margin will stop making capital investments because of the increase in the incremental cost of capital. For example, a business, with a marginal cost of capital at the prime rate of 5.25% at the beginning of 2005 may have considered investment opportunities with a higher expected rate of return then the cost of funds (prime rate 5.25%). However, today's prime rate of 7.25% would discourage the same business from making the same new capital investment due to the 2% marginal increase. The rise in the Federal Funds rate and prime rate will at the margin stop business from making new capital investments that were attractive just 12 months previous.

From a macroeconomic point of view, we are concerned because underlying corporate earnings have grown very strongly over the past three years and it becomes more and more difficult to continue to meet or exceed earnings estimates in a rising interest rate environment. We believe the fixed income market is a "flashing yellow light" warning us to be cautious as we look forward to the 2006 markets. We see that GDP, revenue and earnings should continue to grow strongly in 2006, but we will continue to monitor these indicators closely for potential weakness.

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