Is yield curve's signal red or yellow?

The recent flattening of the Treasury yield curve is seen by some as a signal that last month's stiff does of credit tightening by the Federal Reserve will soon slow the economy.

But whether the rates are telegraphing a recession or a mere lull in the current expansion is still up for debate.

"There could be a pause next year. That wouldn't be atypical, although the economy shows few sign of it right now," said Gary Schlossberg, senior economist at Wells Fargo Bank, San Francisco.

Others feel a stronger chill in the air. "I'm guessing, and I use that word deliberately, that a recession will start in the second quarter," said A. Gary Shilling, an economist and business consultant based in Spring-field, N.J.

The yield curve is the line formed by market rates across various maturities of government debt. The differential between shorter and longer maturities of government debt has been halved since the Fed pushed up short-term rates by 75 basis points Nov. 15.

It was the central bank's sixth and largest rate hike of the year.

A flattening curve is regarded by economists and investors as a likely harbinger of an approaching peak in both economic activity and interest rates.

"We are beginning to see more late-cycle behavior" in both rates and the financial markets, said Robert G. Dederick, economic consultant to the Northern Trust Co., Chicago.

"But that does not mean the end of the cycle," he cautioned. "And the end can require a very long time," with possible false signals along the way.

Yield curve flattening develops, Mr. Schlossberg said, as longer-term rates, highly sensitive to inflationary expectations, stabilize ahead of an anticipated slowing of the economy.

"This occurs even as shorter-term rates are pushed higher by the Fed's monetary tightening to assure that inflation will slow," he said.

Are we at that point in the business cycle? Mr. Scholssberg doesn't think so. He notes that the short-term "front end" of the curve "is still steep enough to accommodate several more interest rate hikes by the Federal Reserve in 1995."

He pointed to the yield gap between three-month Treasury bills and two-year Treasury notes. On Friday afternoon, the bills yielded 5.80% and the notes 7.51%, a differential of 171 basis points.

"This unusually wide gap makes it all the more likely that much of next year's increase will be in the short-term money market investments, much as it normally is at the stage of the business cycle," he said.

Right now, he sees little evidence that the economy is running out of steam. "Employment, incomes, consumer confidence and foreign trade appear strong enough to overcome any temporary slowdown," he said, "setting the stage for moderate, sustainable growth of 2.5% to 3% over the course of 1995.

Mr. Shilling also expects further rate hikes from the Fed, but he thinks the economy will be downshifting more rapidly than does the Wells Fargo economist. "I think we will be seeing a flat-to-inverted yield curve from here on," he said.

"Consumers have been almost unscathed by the higher rates so far, jobs are more available and people feel more secure. All this means the Fed will have to raise rates even further to get their attention," said the economist.

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