Bond Yield Inversion Suggests Economic Uncertainty

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John Lonski, chief economist at Moody's Investors Service, discusses unusual movement in the bond market Tuesday. For the first time in five years, the two-year treasury yield rose above the 10-year treasury yield. Lonski says this inversion may indicate an uncertain economic outlook for 2006.

ROBERT SIEGEL, host:

And now on to borrowing on a bigger scale. Yesterday, for the first time in five years, interest on long-term bonds dropped below interest on short-term notes. It's not supposed to work that way. If you assume the added risk of lending your money for a longer period of time, you should be able to demand a higher rate of interest. So what does this so-called inversion mean? That's our question for John Lonski, who's chief economist at Moody's Investors Service.

Mr. Lonski, what's your explanation of this inversion?

Mr. JOHN LONSKI (Chief Economist, Moody's Investors Service): Well, the historical record shows that as investors become more worried or concerned about future economic prospects, the Treasury yield curve tends to flatten; that is, the 10-year Treasury yield moves down closer to the two-year Treasury yield. So this latest flattening of the Treasury yield curve reminds us that investors are less than convinced that 2006 will be yet another year of above-average economic growth.

SIEGEL: Less than convinced...

Mr. LONSKI: Right.

SIEGEL: ...you say?

Mr. LONSKI: Yes.

SIEGEL: I mean, we've had so many economic reports of big economic growth in 2005. We're under the impression that we're in full recovery in the economy. Where does all of this uncertainty come from?

Mr. LONSKI: The uncertainty's coming from worry regarding the ability of consumers to continue to spend at a rate that is well in excess of the rate of personal income growth.

SIEGEL: You mean--we just heard an interview about credit card restrictions. If Americans get sober with their plastic, that could throw the economy into a tailspin is what you're telling me.

Mr. LONSKI: Yes. That would imply a slower rate of growth for consumer spending and in all likelihood the same for the overall economy.

SIEGEL: Well, how certain an omen is this sort of inversion? The Wall Street Journal reports that when it happens, it often precedes a recession. Often? Always? Sometimes? What would you say?

Mr. LONSKI: Sometimes. Thus far the inversion of the yield curve has been neither severe nor especially long-lived. So it's far too early to conclude that a recession will necessarily strike hard at the US economy during the next 12 months.

SIEGEL: So on a scale of one to 10--these are my own metrics. On a scale of one to 10, where one is pretty flaky day in December and 10 is `Watch out, the crash is coming in the next year,' what number do you assign what's happened here?

Mr. LONSKI: I would give it a three.

SIEGEL: A three. Well, Mr. Lonski, thank you very much for talking with us.

Mr. LONSKI: My pleasure.

SIEGEL: John Lonski, who is chief economist at Moody's Investors Service.

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