Everybody dance now! The recovery is on the way! The yield curve has turned positive once again!
The who has turned what?
Forgive me a moment while I go all wonky: The yield curve measures the relationship between short- and long-term interest rates. When it looks like smooth sailing on the horizon, the slope of the curve is positive: long-term bonds pay more than short-term ones as a way of rewarding bond buyers for investing for the long haul. When things start to look iffy, investors seeking safety pour into longer-term bonds, pushing up their price and pushing down their yields. When the yield curve inverts like this, watch out: you can be pretty sure a slump is coming.
Right now, though, the slope is happily positive, with ten-year treasuries yielding a couple percentage points more than the fed funds rate (now near zero). Chris Dallow at Investors Corner argues that this means "a strong reason to expect the economy to recover within the next 12 to 18 months."
This isn't all economist hoodoo: as Dallow notes, the yield curve has historically been "an excellent predictor of economic fluctuations - much better than professional economic forecasters."
You can see his piece for links to the academic research on this; for more wonky details on what's going on now, check out what two economists at the Cleveland Fed say about it all.
But you might not want to celebrate just yet. Some smart economists think this historically accurate indicator may not be worth much at this particular point in time. Paul Krugman argues in his blog at the New York Times, that the fact that the fed funds rate is currently a big fat zero throws a monkey wrench into the formula:
"If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.
But here's the thing: the Fed can't cut rates from here, because they're already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it's like an option price: short rates might move up, but they can't go down."
In his piece, Dallow argues that this and similar worries are "overstated," and offers some evidence that "the yield curve has been a good forecaster especially when short-term rates have been low." (Emphasis added.) In other words, there are good arguments on both sides of the debate.
My take? As much as I like Krugman, I'm leaning towards seeing the positive yield curve as a tiny little ray of hope. Like Fox Mulder and William James, I want to believe.
-- David Futrelle