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Soft and flat? Danger!
Slow growth signs and flattening interest rates have economists and investors seeing trouble ahead.
June 6, 2005: 3:04 PM EDT
By Chris Isidore, CNN/Money senior writer
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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 sign came Friday, when the May job growth was the slowest in two years. But that only followed a week that saw a manufacturing executives suggest the two-year industrial expansion may be running down, and another report showing a big jump in planned layoffs last month.

"Today's disappointing labor report supports the notion that the emerging soft patch in the U.S. economy is here to stay," said Ashraf Laidi, chief currency analyst for MG Financial Group.

Economists are now projecting the United States could see slower economic growth in the second half of the year, perhaps in the 2.5 to 3 percent range, rather than the 3.3 percent to 4 percent growth of the recent past.

Placing slow growth bets

But far more important than past economic numbers or economists' forecasts are investors' ever-bigger bets in the bond market on slower growth ahead. This reflects a growing belief on Wall Street that the Federal Reserve may soon pause from, or even halt, its quarter-point rate hikes sooner rather than later.

Following the May employment report the yield on the benchmark 10-year treasury fell to a 14-month low early Friday. Even though long-term bond yields have rebounded from the low right after the jobs report, they remained below 4 percent on Monday.

"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 longer-term Treasury securities such as the 10-year note have fallen over the past year, even as shorter-term rates, such as the Fed's key short-term rate, the fed funds rate, or the 3-month Treasury yield, have steadily gained ground.

The condition is known as a flattened yield curve -- a warning sign for the economy that economists take seriously.

History tells us that as short- and long rates get closer, slower economic activity is almost sure to occur. If short-term rates rise above longer-term rates, a recession is virtually always in the offing. The last time the yield was inverted was from July through November 2000, right about when the last recession began.

Even with the modest rebound in the 10-year yield, the gap between the weekly averages for 3-month and 10-year Treasury yields was only 0.96 percentage points for the week ending June 3, according to figures from the Fed -- the narrowest gap since April 2001.

Flat's a drag

That's of particular concern, according to economists, because 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 said that when there's a large gap between short- 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 short-term rates are on par with or higher than long-term rates, it sucks oxygen from the financial economy," he said. "It deprives lenders of profitable operations, 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 short rates outstripped long rates and both were around 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."

Vitner said even if there is an inverted yield curve at these levels, it wouldn't necessarily mean a recession as long as long rates didn't drop too far below short-term rates, or stay lower for too long. He puts the risk of a recession at roughly one in six.

Vitner's view is echoed by Bernard Baumohl, executive director of the Economic Outlook Group of Princeton, N.J. He said when the spread between long and short rates narrows but both remain below 4 percent it's "just not problematic for an economy with a low underlying rate of inflation and still healthy productivity growth. There's still plenty of liquidity out there and the cost of capital remains relatively cheap."

Some economists also argue that several unique factors are contributing to low long-term rates, including slow growth in many economies overseas, a flight to quality in the bond market after GM's bonds got cut to junk, and big purchases of Treasuries by foreign central banks.

But that said, most economists say the narrowing gap even at today's yields is a caution sign on economic growth.

"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."

MG Financial's Laidi said the narrowing spread yield spread is a big reason for the weaker-than-expected economic reports this week.

Is the Fed to blame?

Fed Chairman Alan Greenspan has called the low long-term rates in today's environment a "conundrum." Some economists say part of the problem with the narrowing yield spread is due to the Fed's insistence on raising rates more than is justified by current economic conditions.

"The conundrum is the Fed, and why the it keeps raising rates," said economist Robert Brusca of FAO Economics.

But Greg Valliere of Stanford Washington Research Group, said the central bank is right to keep raising rates due to concerns about issues such as rising labor costs, which could lead to more inflation down the road, and the risks posed by a possible housing bubble.

Valliere thinks 10-year Treasury yields will start rising as soon as investors become convinced the Fed is not as close to abandoning its policy of rate hikes as now commonly assumed.

"I don't think it's going to flatten totally," he said about the yield spread. "You can't fight the markets, but I think the markets are being unrealistic right now."

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

This is a update of a story that originally ran on April 27, 2005.  Top of page

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