Yield Curve & the Fed Rates

Simple yet optimistic view of the US economy

By Chris Isidore, CNN Money senior writer.

May 24, 2006: 3:35 PM EDT

NEW YORK (CNNMoney.com) - Three of the scariest words in economics used to be "inverted yield curve."

The condition, which occurs when long-term interest rates are lower than short-term rates in the Treasury bond market, was once seen as a pretty clear signal of a recession ahead.

And while that's changed - many economists now say an inversion is more a sign of a slowing economy than a coming recession - the action in the bond market Wednesday morning had some experts saying the Federal Reserve may finally be forced to pause in its rate-hiking campaign so as not to upset financial markets.

"It's not among the top five things they're reading, but I don't think they're ignoring it totally," said Tom Schlesinger, executive director Financial Markets Center, a research firm that follows the Fed closely.

The inversion early Wednesday was different than the inversion that occurred late last year and early this year, when the 10-year Treasury yield fell below the yield on shorter-term Treasury securities.

Wednesday's inversion came as the 10-year yield fell briefly below the fed funds rate, the Fed's short-term rate target, currently 5 percent. It was the first time that's happened since April 2001, the last time the country was in a recession.

The 10-year yield dipped briefly below the fed funds rate Wednesday morning after a report showed a big drop in demand in April for cars, refrigerators and other big-ticket items known as durable goods.

But when a report on new home sales came in above forecasts 90 minutes later, the 10-year Treasury yield edged back above the 5 percent level.

"Ever since the Fed said decisions on future rate hikes would be data dependant, all of a sudden all the numbers matter," said Kevin Giddis, managing director of fixed income at Morgan Keegan.

And even if Fed officials have downplayed the threat of an inverted curve, some economists said the Fed will be reluctant to get too far ahead of where bond investors are betting rates will go.

Last winter, the Fed could keep raising rates without pushing the fed funds rate past the 10-year yield.

But in recent comments, Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead.

"In previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint," Bernanke said in a speech in March. "This time, both short- and long-term interest rates -- in nominal and real terms -- are relatively low by historical standards."

Ian McCulley, analyst with Grant's Interest Rate Observer, a financial newsletter, said he doesn't think the Fed will feel constrained by the recent moves in the bond market.

"The curve (between the 3-month and 10-year) was inverted or flat earlier this year and they tightened into that," he said.

The narrow gap between long-term and short-term rates is something Greenspan famously referred to as a conundrum, and the flat or inverted yield curve seen Wednesday is just the latest example of that puzzle, experts said.

Even if there was more of a gap until recently, it was still narrow by historic standards, said Schlesinger. "I'm not sure how much the conundrum ever went away," he said.

It's also true that the inversion Wednesday was short-lived and relatively narrow. Some of the pre-recession inversions in the past were far more pronounced.

For example the gap between the 10-year yield and the fed funds rate were inverted for nearly 11 months and the gap reached 1.5 percentage points in January 2001, just before the Fed started cutting rates.

The recession that started in late 2000 lasted until the fall of 2001.

Still, an inverted yield curve is not something that can be ignored, the experts said.

"I think it would be healthy to be concerned, given the track record of the curve being a warning sign," said Schlesinger. "It's important not to be trapped by past patterns. But it (the inverted yield curve) does raise a question about how far the Fed has to tighten."

Giddis and Schlesinger both said they're skeptical that an inverted yield curve now will mean a recession later this year

More likely? It's signaling slower economic growth ahead. And maybe an end to Fed rate hikes sooner rather than later.

World Economy Rising

Nice detail of as to how interlaced the world economy is.

By Brian Love, European Economics Correspondent

PARIS (Reuters) - Global economic growth is speeding up and has spread to weak spots such as Japan and Europe without sparking a surge in inflation so far, the OECD said on Tuesday.

Chief Economist Jean-Philippe Cotis voiced concern, however, over high oil and commodity prices, which the OECD said were likely to stay high because of strong Asian demand despite a sell-off in markets in recent days.

Growth in the 30 mostly industrialized economies of the OECD is forecast to expand 3.1 percent overall this year, up from 2.8 percent in 2005, the Organization for Economic Cooperation and Development said in its Economic Outlook, a twice-yearly report.

"The ongoing expansion is entering its fifth year," it said.

"Notwithstanding the headwinds from high and volatile energy prices, it is projected to continue and even broaden this year and next."

That echoed the International Monetary Fund, which in March forecast worldwide economic growth of 4.9 percent in 2006, the best in 30 years barring an exceptional year in 2004.

Like the IMF, the Paris-based OECD said that current account imbalances -- surpluses in China and Japan and deficits in the United States -- posed a continuing and perhaps mounting threat.

"A brutal unfolding of such imbalances would hurt the world economy," chief economist Jean-Philippe Cotis said.

The OECD forecast U.S. growth of 3.6 percent in 2006 and 3.1 percent in 2007 after 3.5 percent in 2005.

For the euro zone, it predicted GDP growth of 2.2 percent this year and 2.1 percent in 2007 after 1.4 percent this year.

For Japan it forecast 2.8 percent growth this year and 2.2 percent in 2007, from 2.7 percent in 2005.

CHINESE INFLATION REMEDY

The OECD made a first attempt to quantify how globalization and cheap Chinese and broader Asian exports affect prices and it reported a greater inflation-limiting impact in Europe than in the United States.

From 2001 to 2005, imports from China and other Asian countries knocked the U.S. rate of inflation down by 0.1 percentage points each year, and trimmed Europe's inflation rate by nearly 0.3 percentage points a year.

Chinese exports have risen four-fold in 15 years.

But Cotis said it remained to be seen whether this benefit was not more than offset by insatiable demand for oil, metals and other commodities in China and other rapidly developing economies of Asia, and the resulting upward pressure on prices.

"Experience over the past three years suggests commodity price pressures may significantly outweigh the disinflationary influence of low-cost manufacturing imports," Cotis said.

The OECD report, which assumes oil prices will stay around $70 a barrel this year and next, predicted a rise in the overall inflation rate for the OECD region to 2.2 percent this year but a retreat the year after to 2.0 percent, where it stood in 2005.

Cotis was sanguine about the recent bout of investor nerves, which drove some stock markets to five-month lows and triggered a run on metals from 25-year records in some cases over the past couple of weeks, with a partial recovery on Tuesday.

"If it was a mistake to be over-optimistic then, it would be a mistake to be over-worried now," he said. Markets had enjoyed years of calm and recent gyrations needed to be put into perspective, he said.

BUBBLE, BUBBLE...

The OECD report, however, did voice concern about what the organization sees as more serious risks for the longer term.

It said a risk of housing market downturns had become more pronounced in the United States, France and Spain but depended partly on future interest rate developments.

It echoed the view that monetary policy was getting more restrictive after years of super-cheap lending but said it would be unwise to rush into more rate rises in the 12-nation euro zone, and that the Japanese central bank should not raise rates until next year.

The OECD predicted a further quarter-point rise in the key U.S. policy rate to 5.25 percent, then a pause followed by a possible cut of the same size a year from now.

"A light 'tap on the brakes' seems necessary to keep the economy in balance," the OECD said.

It advised the Bank of Japan to keep rates at close to zero until the end of 2006 while awaiting proof that Japan's totally different problem of deflation was a thing of the past, suggesting a rise to 1 percent by end-2007 could follow.

It reserved its most eye-catching advice for the ECB, which the financial markets believe is itching to raise its key euro zone rate from 2.5 percent as early as next month.

The OECD assumed the ECB would raise rates by another 1.25 percentage points gradually, but only from later this year, once hard economic data had confirmed a full-blown recovery.

Chief economist Cotis said the ECB should hold fire until October, after second-quarter GDP data would presumably have confirmed a recovery which is so far looking stronger in "soft" confidence surveys than in "hard" data such as GDP figures.

IMF chief Rodrigo Rato said the same thing in Vienna on Monday, remarking: "We see the need for monetary policy to be very aware in Europe of the first stage of the recovery."

Klaus Liebscher, Austrian member of the rate-setting council of the ECB, offered a sharp riposte.

"I think every institution should care about its own duties. Interest rate policy is done by the ECB. And we have to make our decisions based on our own findings," he told Reuters when asked about the OECD's advice during a conference in Vienna.

As the OECD report was released, Germany published some more positive news, saying long-flagging domestic consumption had picked up and contributed significantly to first quarter growth.

The OECD also highlighted the strong performance of some of the countries which are not part of its membership.

Brazil is set to pick up after a disappointing 2005 compared to other emerging market economies, the OECD said, predicting growth rising to 3.8 percent from 2.3 percent in 2005.

China, now the fourth largest economy in the world, is predicted by the OECD to grow 9.7 percent this year.

India is set to secure economic growth of 7.5 percent, while oil-rich Russia can expect 6.2 percent, the OECD said.

(Additional reporting Anna Willard in Paris, David Milliken in Frankfurt, Boris Groendahl and Stella Dawson in Vienna)

US Dollar, Gold & Inflation

A good indicator as to why US Inflation isn't a cause of concern yet!

From CNN Money By Tomi Kilgore, MarketWatch
Last Update: 8:21 AM ET May 22, 2006

Gold futures fell early Monday, and appeared set to suffer their fourth-straight loss, with gains in the U.S. dollar helping apply the downside pressure.

Gold for June delivery was down $10.50, or 1.6%, at $647 an ounce in electronic trading. It hit a low of $636.80 earlier in the session, the lowest price seen since April 28.

The StreetTRACKS Gold exchange traded fund (GLD : 65.59, -1.87, -2.8%) lost $1.28, or 2%, to $64.30 in Instinet pre-open trading.

The front-month contract had lost $35.40 an ounce over the previous three sessions, and had dropped $64 an ounce since closing at a 26-year high of $721.50 on May 11.

The U.S. dollar was up 0.7% against the yen at 112.48, and reached a 2-week high of 112.94 in overnight trading. The buck was 0.1% better vs. the euro at $1.2750.

Gold is widely viewed as a hedge against an increase in inflation, while a rising dollar is seen as helping contain inflation.

In other metals markets, July silver fell 19 cents, or 1.5%, to $12.17 an ounce and July copper slumped 9.4 cents, or 2.7%, to $3.3750 a pound.

July platinum shed $33.40, or 2.5%, to $1,280 an ounce and June palladium dropped $10.80, or 3.1%, to $341 an ounce.

Gold Rises to 25-Year High

This is a classic example of speculation rather than economics.

Bloomberg - Gold rose to a 25-year high in New York as increased tension between Iran and the U.S. spurred investors to buy the precious metal as a haven and a hedge against inflation.

The U.S., U.K. and France are trying to get support in the United Nations Security Council for a resolution demanding Iran quit enriching uranium. Oil prices have surged to a record on concern exports from Iran, the world's fourth-largest producer, may be disrupted, stoking inflation.

``Gold may rise to $1,000 before June should the situation in Iran intensify,'' said Bernard Sin, chief trader at Geneva-based MKS Finance, a precious-metals trading and refining company.

Gold futures for June delivery rose $4, or 0.6 percent, to $680.50 an ounce at 9:31 a.m. on the Comex division of the New York Mercantile Exchange. Prices earlier reached $687, the highest since October 1980.

AngloGold Ashanti Ltd., the world's third-largest gold producer, said the gold market is ``set for a sustained positive cycle.'' The company's quarterly loss narrowed as it benefited from the higher gold price.

Bernard Swanepoel, chief executive officer of Harmony Gold Mining Co., Africa's third-largest gold producer, said he expects prices to rise further.

Barrick Gold Corp., the world's largest gold producer, has said it's cutting forward gold sales, which lock in prices, to take advantage of rising prices.

Oil Shipments

``This is clear evidence of producers' positive outlook about the gold price,'' John Meyer, an analyst at London-based Numis Securities, said in a report.

Iran would probably retaliate for any military strike against its nuclear facilities by trying to choke off oil shipments through the Strait of Hormuz, military planners said.

The U.S., U.K. and France yesterday circulated a draft UN resolution that demanded Iran ``suspend all enrichment-related and reprocessing activities, including research and development.'' The three countries have said Iran is developing nuclear weapons, a charge Iran has denied.

The draft resolution ``is extremely unhelpful and won't get anywhere,'' Iranian Ambassador Javad Zarif said. ``Iran does not respond to threats and intimidation.''

``It's the same story of Iran, inflation concerns and rising oil prices,'' said Charles Dowsett, head of trading of precious metals at ABN Amro Holding NV in Sydney.

Stock Crash

Marc Faber, author of a newsletter called The Gloom, Boom & Doom Report, yesterday said that gold is becoming the ``global currency of choice.'' Gold may surge to $6,000 an ounce in the next decade, and possibly to as much as $10,000 depending on U.S. monetary policy and the level of the Dow Jones Industrial Average at that time, he said

Faber told investors to bail out of U.S. stocks a week before the 1987 Black Monday crash.

Some investors buy gold to hedge against inflation, which erodes the value of fixed-income assets such as bonds. They also buy bullion as a haven against instability in financial markets caused by geopolitical tension.

Crude oil in New York reached $70.70 a barrel today and has gained 38 percent in the past year. Oil climbed to $75.35 on April 21 and April 24, the highest since trading began in 1983, partly on concern over the Iranian dispute. Oil more than doubled in 1979 after a revolution in Iran cut the nation's oil exports.

``We're currently in territory not even contemplated six months ago,'' said Ron Cameron, a Sydney-based analyst at Ord Minnett Ltd. ``The price seems to have momentum on its side.''