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The yield curve refers to the interest rates on bonds of varying maturity. Normally, we expect the yield on bonds with longer maturities to have a higher yield than those of shorter maturity bonds. Because it is less of a burden to tie up one's money for three months or a year, rather than five years or ten years, investors must be given an incentive to place their funds in bonds of longer maturity. This incentive takes the form of a higher interest rate paid on bonds with longer duration. Similarly, we can justify the higher yields on longer maturity bonds based on risk: the foreseeable risk to the economy over the next three-months or year is much less than the risk over five or ten years. Thus the higher yield on long-dated bonds is required to compensate for the added risk of holding an investment that long.

On December 30, 2005, many newspapers heralded the fact that the yield curve on U.S. government bonds had become inverted. In fact, the curve was not consistently inverted. The yield on two-year Treasury notes (just under 4.4%) barely exceeded the yield on ten-year Treasury notes (4.39%). Ordinarily, this type of yield structure will be a self-correcting problems. Investors will no longer choose ten-year bonds, when they can get the same interest rate or even a higher one on two-year bonds. With fewer people wanting to hold ten-year bonds, the interest rates will rise on these in order to clear the market and induce investors to hold ten-year bonds once again.

But when long-term interest rates rise, so too do rates on 15-year and 30-year residential mortgages. If the costs of obtaining a mortgage loan rise, then fewer people will want to buy houses. The result could be either a cooling of the previously hot real estate market, or a potential collapse of some regional price bubbles on real estate.

If inverted yield curves were merely a transitory phenomenon with little or no economic impact, except for people in the business of trading interest rate derivatives, swaps, and bonds; then no one would worry. However, inverted yield curves have often signaled a recession will follow, and the potential for a recession is a legitimate cause for worry.

It would take more than one sign of an impending recession before most economists would start to worry. At the start of 2006, American businesses are expected to increase investments on capital equipment, which should be a boost to the economy. The major cause for concern is the seemingly ever rising foreign trade deficit. Americans consume more than they produce and make up for the difference with imports. Foreign businesses that sell goods to America often invest the proceeds in U.S. government bonds. Because so many of our imported goods are produced in China, the U.S. now has a significant portion of its long term government bonds held by Chinese investors. The U.S. faces political risk that the Chinese investors may one day decide to cut back on their dollar holdings and place their cash in some other government's bonds.

An article published on Dec. 31, 2005, in the Financial Times (London, England) noted *Each of the last six US recessions has been preceded by an inverted yield curve, [but] . . . it has sent out two "false positives", inverting in 1966 and 1998.* As noted above, with yields of 4.39% and approximately 4.40%, the yield curve between two-year and ten-year is actually more flat than inverted. For now, in the first week of January 2006, the best course is to wait and see if the yield curve becomes more inverted or reverts back to its normal shape. As a professional economist, I will not begin to worry unless the yield curve remains flat for over a month, or the inversion increases from 0.01% to 0.50%.

For additional articles by this author on financial economics, please see http://michaelguth.com/finecon.htm