Flattening Yield Curve Points to Cooler '98 Economy

The Treasury yield curve, considered one of the best leading economic indicators, is signaling a business slowdown next year.

The curve recently flattened to a spread of less than 1 percentage point between the yields of the Treasury Department's shortest- and longest- maturing securities, meaning lower interest rates are probably ahead.

The spread narrowed Friday to just 82 basis points after an unexpected 0.2% decrease in October retail sales was reported. By comparison, the spread was 171 basis points in June.

"Previously when the yield curve flattened to this extent, GDP growth slowed to around 2% the next year," noted Bruce Steinberg, chief economist at Merrill Lynch & Co.

Mr. Steinberg continues to forecast 2.5% economic growth next year, but he acknowledged "the yield curve indicates the risks are to the downside."

A widening gap between yields of short and long maturities, referred to as a steepening yield curve, means quickening economic growth and higher prices ahead; a flattening curve telegraphs moderating growth and inflation.

An inverted yield curve-when yields on long maturities dip below those on short maturities-warns of recession. Most recently, the curve flipped over in mid-1989, and a recession came the next year.

Others see things differently. Though the Fed last week opted against tightening interest rates, a rate hike is still widely expected. "The Fed can wait, but they will brake," asserted Robert A. Brusca, chief economist at Nikko Securities Co.

Mr. Steinberg said he thinks "they" already are tightening. Usually, the yield curve flattens as the Federal Reserve raises short-term rates, he noted. In fact, it was last this flat in early 1995 after a year of Fed tightening.

While the central bank has not actually raised rates in six months, falling inflation has effectively tightened Fed monetary policy, the economist said.

"In our opinion, the Fed is anchoring the entire yield curve by holding the federal funds rate at 5.5%," he said. He anticipates a relaxation of policy next year.

The phenomenon of high real rates is international, noted Edward Yardeni, chief economist at Deutsche Morgan Grenfell Inc. The spread between long and short bond yields in the Group of Seven industrial economies has narrowed by 110 basis points this year.

"The flattening of the global yield curve suggests global economic growth could weaken significantly next year," he said. He cut his forecast for U.S. growth next year to 2% from 3% and put the probability of a recession at 25%.

Mr. Yardeni criticized central banks in Canada and Europe for recently raising short-term rates to preempt inflation. The moves amount to "attacking a retreating enemy," he said.

Moreover, the central banks' actions risk "provoking the deflation gods," said the economist, who said he believes the end of the Cold War closed a 50-year inflationary era.

"History shows that inflation occurs during war times while deflation is the norm in periods of peace," he said. "To avoid a repeat of history, central banks must offset the forces of deflation with easy money.

"Indeed," he said, "recent events in Asia suggest that global deflation may be inevitable even with easy money."

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER