November 2005

An Inverted Curve?

The Senate has confirmed Mr. Ben Bernanke to become Chairman of the Federal Reserve Board upon Mr. Greenspan’s exit at the end of January 2006. It is unlikely that Mr. Bernanke will veer far from the path pursued by Mr. Greenspan, at least during the first few months of his term. His challenge will be focused on maintaining confidence in the banking system and fostering economic growth. During the Senate hearing, Mr. Bernanke stated “I do in no way intend to make any significant change in the overall approach to monetary policy developed under Chairman Greenspan.”

We believe that Wall Street has priced in another 50 to 75 basis point hikes in the targeted Fed funds rate. With short term rates rising and longer term rates steady to lower, the yield curve is flattening and could become inverted. Historically, an inverted yield curve is an indicator of looming recession, and is commonly known as a liquidity crunch, where the cost [risk] of borrowing short exceeds that of borrowing long. At this writing, there are only 66 basis points difference between the 3-month Treasury bill and the 30-year Treasury bond. Demand for ten-year and longer Treasuries has picked up in recent weeks as corporations rush to repatriate overseas profits ahead of a burdensome tax change that becomes effective in January 2006. Although the heavy foreign inflows of funds into U.S. Treasuries recently have skewed the yield curve, the spread between short and long term rates has been narrowing since the Fed began raising rates in mid-2004.