Jim Hamilton at Econbrowser offers a useful summary of some of the issues surrounding the recent inversion of the yield curve in the US. In the past, whenever long-term interest rates have dipped below short-term interest rates, there’s been a better-than-decent chance that a recession would follow. Brad DeLong explains why:
Usually an inverted yield curve is the result of a lot of domestic investors’ thinking the Fed is going to cut short-term interest rates over the next couple of years, and so buying medium- and long-term bonds to lock in higher yields and reap hoped-for capital gains as interest rates fall. What makes the Fed cut short-term interest rates? A recession.
But Brad DeLong doesn’t think this particular episode is worth getting too worked up about:
This inversion of the yield curve, however, is generated not by domestic investors’ thinking that a recession is on the way, but by foreign central banks’ desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating.
Thus while an inverted yield curve is usually a sign that a bunch of people are trading bonds on their belief that a recession is likely, that is not what is going on in this case.
That’s a plausible story, but I don’t think it’s correct.
If bond markets thought that there was little chance of a US recession in the near future, then the term structure of Canadian interest rates wouldn’t be following US patterns. No-one’s going to make any particular effort to prevent their currency from appreciating against the CAD, and since Canadian macroeconomic fundamentals are so strong, the only major thing that we have to worry about is the possibility of a US recession.
Here’s a graph of the Canadian and US yield curves from December 2005 and December 2004:
It looks as though bond traders in both markets are expecting the same thing: a slowdown (or worse) in the US – and therefore Canada – for 2007. And it also seems as though they’re expecting the CAD to appreciate even further against the USD.
Worthwhile Canadian Initiative 
I’m less concerned about the inverted yield curve — tightening a bit short term could instill continued confidence that inflation won’t become a problem in the future and, a la the Fisher Equation, generate the inversion.
What puzzles me is the slight u-shape to the yield curve. What on earth causes that?
Did you see the yield curve graphs in this NY Times piece?
The UK yield curve appears to have been inverted for a year.
Australia too has had an inverted yield curve for some time. The UK is a more comparably sized economy with a similar outsized residential real estate market, but I wonder if the US economy is still different enough (ie relative global giant) to hold some reservations about these comparisons. Argentina could not carry a 6% debt/GDP load, so many (among them, Setser and Roubini) wondered about what the US could carry. More than 6% apparently, but perhaps not much more.
I’m not sure how firmly we can tie inverting yield curves to currency fluctuations, but the confidence level expressed in the following seems a tad heavy:
“No-one’s going to make any particular effort to prevent their currency from appreciating against the CAD, and since Canadian macroeconomic fundamentals are so strong, the only major thing that we have to worry about is the possibility of a US recession.”
The CAD has been targeted in fx markets before and some feel that their outsized trade position with the US puts them at more risk than say, Korea whose fx positions are currently attracting some attention.
It looks like Korea’s substantial US reserves are insufficient to maintain (against currency speculators) a competitive currency. It looks like foreign cbs can be manipulated to buy US tbills and exacerbate a dismal looking US trade position.