Real bond traders have curves

David Andrew Taylor, author of great blog titled Dismally, wrote a post about the yield curve yesterday. I made a comment, he replied, and it got my blogging juices flowing, so I thought I'd make a more indepth comment here.

There has been considerable discussion about how good a forward indicator the slope of the yield curve is. Back in March, some dude named Ben Bernanke said the following:

"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, this time, both short- and long-term interest rates -- in nominal and real terms -- are relatively low by historical standards."

Dr. Greenspan made similar comments just before retiring.

I think the Fed is down playing the inversion to serve their own purposes. As I've commented before when writing about the forward yield curve, longer-term rates are unbiased predictors of short-term rates. So if long-term rates are lower than short-term rates, than means that the market widely anticipates falling short-term rates. Why would short-term rates fall? Because the Fed is cutting. Why would the Fed cut? Because the economy stinks.

Is Greenspan and Bernanke suggesting they don't believe in efficient markets? That long-term rates move randomly and traders ignore the likely future path of short-term rates? I seriously doubt it. More likely, they believe that the curve is a perfectly good indicator of where short-term rates are going, but that they wanted longer rates to rise. They knew that their goal of tightening the money supply would be better served by rising long-term rates. They also wanted the market to presume the Fed was going to continue to hike their target rate for some time. By dismissing the inverted yield curve, they are emphasizing their focus on fighting inflation.

As to whether we have a recession or not, I think its a bit of semantics. I mean, if real growth averages under 1% for 4 quarters, does it really matter whether two of those quarters happen to be negative or not? I think that between 3Q 2007 and 3Q 2008, we will see GDP growth average 1-2%. That's plenty weak to cause a bond market rally. That's really all I care about.

P.S. Blogger's spell check rejects the word "blogging." That's your deep thought for the day.