If you think it is hard for an economist to imagine a world with "free lunch" as the natural order, consider this: It is even harder for him/her to imagine the U.S. economy with an inverted yield curve as the prevailing and, well, "normal" structure of interest rates in the ordinary and usual state of economic affairs. Nevertheless, in these extraordinary times of prolonged and stable national economic growth, it is well worth examining the possibilities.

The "normal" yield curve, of course, describes the term structure of interest rates wherein a lender will forebear the use of money for longer time maturities only by charging higher rates of interest; a phenomenon which describes an upward sloping curve that tends to flatten at increasingly longer maturities. Why this profile should be considered normal is perhaps best explained by the oft cited hypotheses of [a] expectations, [b] liquidity and [c] segmentation. The expectations hypothesis suggests that the institutionalized inflation psychology embedded in the U.S. translates into a propensity of wealth holders to adjust their portfolios in favor of shorter versus longer term instruments; ergo a positively sloped yield curve. The liquidity hypothesis posits that a preference to liquid (ie. shorter lived) versus less liquid (ie. longer lived) financial instruments again results in a normal yield curve configuration. Finally, the segmentation hypothesis theorizes that a host of institutional rigidities (e.g. regulatory prohibitions, corporate resolutions, market limitations, etc.) preclude facile adjustment of portfolios, thus accentuating and infixing the curve normalizing effects of [a] and [b].

Having defined a normal profile of the yield curve, it remains only to collate what the late, great (and extremely funny) Marty Feldman might have described as "Abbey Normal" (abnormal), the "inverted," or "negative" yield curve. That profile traces out a curve which is downward sloping to the right, a condition in which short term rates are higher than long term rates and in which lenders demand less compensation for successively longer lived loans. Why would such an eventuality be considered abnormal? Simply because of the relative infrequency of the condition, which typically precedes a recession. It is generally associated with the later stages of an economic boom cycle, wherein capacity utilization is stretched to the limit, resource allocation is rife with bottlenecks, unemployment is at a cyclical low, interest rates are rising due to an excess demand for money and the bugbear of inflation has raised its ugly head. It is at that point, in the memorialized and facund words of former Fed Chairman William McChesney Martin, that the Fed traditionally "takes away the punchbowl before the party gets too rowdy." Relentless and unremitting rounds of matched sales by that august body’s open market desk operations sends the Fed funds rate soaring relative to long term rates which wealth holder’s bid down in expectations of a recession. Since we generally consider recessions as merely inconvenient, transitory states between enduring expansions, a yield curve that goes flatline, or negative seems fraught with misology and entirely unintuitive.

The history of inversions is fairly straightforward. Since 12/65, there have been nine distinct instances of this anomaly as follows:

For purposes of expedition, it is useful to combine periods 1. and 2., periods 3. and 4., periods 5., 6., and 7., and periods 8. and 9. In so consolidating, it is not surprising to observe that the inflationary strains of President Johnson’s Vietnam war buildup, concomitant with the "Great Society" guns and butter economy, resulted in just over four years of almost unbroken inversion from 12/65-07/70. That span was only slightly longer than the inversion marking President Reagan’s denouement of supply side economics; the punitive Volckerean anodyne to the subsequent virulent inflation; astronomical short term interest rates for three years. The 12/65-07/70 period was marked by three bear markets, with a recession finally occurring in 1970. Likewise, a bear market accompanied the 06/73-09/74 period, as did a recession. Two recessions followed the inversions in the 09/78-06/82 period, as well as two bear markets. Finally the inversion period 01/89-09/89 was accompanied by neither a bear market, nor recession. Note that in almost 24 years of history, the yield curve inverted for 8 1/2 years, or approximately 35% of the time.

Empirical evidence seems to infer that an inverted yield curve is necessary, but not sufficient to cause a recession. In other words, not every inversion correctly predicts a recession, but all recessions are preceded by an inversion.

Talk of the "new era" and "new paradigm" for the U.S. economy, now the bon mot of cocktail circuit bavardage, proclaims inflation as dead at the hand of continuingly robust productivity gains. Yet a dichotomy emerges upon closer inspection of current key variables in the economic equation. The parlous rate of growth in consumption and investment demand, including the strength in critical inputs such as industrial production, producer durable goods, factory shipments, non-defense capital goods, housing construction and auto production, juxtaposed to the high level of capacity utilization and record low level of unemployment, suggests that a day of reckoning is nigh at hand.

If the expectations hypothesis has not been repealed, and there is no evidence to the contrary suggesting otherwise, a curious paradox is posed. Why has, and is, the yield curve continuing to flatten in direct contradiction to the widely accepted perceptions that the U.S. economy is now entering a crucial conjuncture, a period which portends the recrudescence of inflationary pressures? Does the consensus really embrace the notion that a recession is on the horizon? Both anecdotal evidence and official monthly economic releases would vigorously refute that precious conceit. So how is this little enigma unriddled?

Under the rubric "Bond Market ‘Vigilantes’ Do a Disappearing Act As Market Prices Continue to Streak Ever Higher," the Credit Markets column in 09/22’s Wall Street Journal cites Edward Yardeni, Deutsche Morgan Grenfell’s chief economist: "The bond vigilantes take their cue from the Fed and they feel the Fed is doing its job."

In answer to the questions above, it could be that the historically demonstrable expectations have evolved to a higher plane. It is possible that the groundswell of confidence in and perception of the efficacy and aplomb with which the Fed manages the nation’s monetary aggregates has ushered in a "new era," a reconstructed paradigm in which an inversion need not be decretive of a recession, but of a stable, non-inflationary, modestly expanding economic environment characterized by a convergence of nominal and real variables?

Note that the 1989 inversion experience was followed by neither a bear market, nor recession. The economy had been mortally incapacitated by a savaged banking sector and, no doubt, the vigilantes anticipated a recession. But it never materialized. Might it not be possible for the vigilantes to justify inversion, or at a minimum a flat yield curve, by embracing the analogue of recession; to wit, non-inflation? The flatline or inversion would be driven not by the expectation of recession, but by the confidence invested in the Fed to maintain a stable and non-inflationary environment, or, if you will, "benign expectations."

Without exception, the incidence of an inverted yield curve has always been accompanied, or followed by a falloff in money supply growth. Currently, M3 is growing at the 37 year trend average of 7.8%, even after the Fed bumped the Fed funds rate by 1/4% last March. Benign expectations have clearly not diminished.

Assuming that by pluck or luck, the Fed has managed to tamp the empirically observed amplitude of business cycle oscillations, it is possible that an extended period of benign expectations could evolve into an institutionalized flat, or slightly inverted yield curve, even as the money supply continues to expand modestly and presuming the Fed continues to initiate only superficial upward adjustments in the Fed funds rate in response to marginal inflationary pressures, should they intrude.

Imagine for the moment that the Fed prophylactically tweaked the Fed funds rate at the 09/30 FOMC meeting in advance of any meaningfully inflation-threatening numbers . More than at any other time in its operating history would the Fed then be regarded as the paladin of a stable, non-inflationary environment. Well ahead of the curve, the implementation would be viewed constructively by the bond vigilantes. As we have already observed since the March tightening, the markets are receptive to prudential Fed management in this unique environment. Under these conditions, the vigilantes just might become flatliners and countenance long term rates at 5 1/2%.

JASBOND

stoman@ns.net

September 24, 1997