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Soft and flat? Danger!
Slow growth signs and flattening interest rates have economists and investors seeing trouble ahead.
April 27, 2005: 12:30 PM EDT
By Chris Isidore, CNN/Money senior writer

NEW YORK (CNN/Money) - Not too fast and not too steep would normally be a good path to follow. Unless, of course, you are hiking in today's land of economics. Then that path, to some, looks pretty scary.

First, the slow part ...

Worries about the strength of the economy abound. The latest troubling sign came Wednesday, when the March report on durable goods orders showed a 2.8 percent decline, the biggest one-month drop in more than two years. The February reading on orders for those big-ticket items also was revised to a decline of 0.2 percent rather than the perviously-reported gain of 0.5 percent.

"The soft spot is looking to be bigger and softer all the time," said economist Robert Brusca of FAO Economics following the report.

Next up is gross domestic product, the broad measure of the nation's economic activity. The Thursday morning report is now forecast to come in at an annual rate of increase of 3.5 percent in the first quarter, according to economists surveyed by Briefing.com. That's down from the 3.8 percent rise in the fourth quarter.

Some economists surveyed by Reuters are forecasting a much lower growth rate for the first quarter, as low as 2.8 percent And while there's yet to be a formal survey of second quarter estimates, the general thinking among economists is that growth of 3.0 percent or less is now expected for the current period, the first time it would fall to that level since first quarter of 2003.

Placing slow growth bets

But far more important than a report on past economic activity or economists' latest forecasts is the moves made by investors, who are making an increasingly large bet in the bond markets on slower growth ahead.

"It's more important what investors believe, because those people are willing to put their money on the line like that," said Rich Yamarone, director of economic research at Argus Research.

Which brings us to the flat part ...

The investment activity that has the attention of Yamarone and other economists is the difference between long-term and short-term rates.

The yields on the longer-term treasuries, such as the 10-year note, have not seen much in the way of gains over the past year, even as shorter-term rates, such as the Fed Funds rate or the 3-month treasury, steadily gained ground.

The condition is known as a flattened yield curve, or a narrowing yield spread. But whichever jargon is used, it is a warning sign for the economy that economists take seriously.

History tell us that as the two types of interest rates get closer, slower economic activity is almost sure to occur. If short-term rates overtake longer-term rates, a recession is virtually always in the offing. The last time that happened was from July through November 2000.

Flat's a drag

That's of particular concern, according to economists, because the current bond market conditions can serve to cut down on credit available to businesses, and thus be another drag on economic activity.

Jim Grant of Grant's Interest Rate Observer newsletter says that when there is a large gap between the short-term and long-term rates, conditions are ripe for financial services firms to make money by extending credit. That in turn fuels economic activity.

"In the opposite condition, when the short term rates are on par with or higher than long term rates, it sucks oxygen from financial economy," he said. "It deprives lenders of profitable operation, and it discourages capital creation."

Some economists say a flattened yield curve is more of a concern when both rates are at high levels, as they were in late 1989, when the short-term rates outstripped long-term rates and both were at or near 8 percent.

"It really depends on when you get the flat curve," said Mark Vitner of Wachovia Securities. "Right now with the low rates, I don't see dire implications from a flattening yield curve. It just is accurately indicating that the economy is slowly or moderating."

But other economists say that even if things would be worse with both rates at higher levels, the narrowing gap even at today's yields is a caution sign that more economic weakness is ahead.

"That (pulling back on lending) is a lot of what you're seeing now," said Argus' Yamarone. "Then you exacerbate the situation by having skyrocketing energy and health care costs, and you start to see why businesses may not be investing as much as we originally thought they would."

For more on the economy and how it affects you, click here.  Top of page

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