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Yield inversion? Not so fast
Among the first to forecast an inverted curve, Cantor Fitzgerald lists factors that may prevent it.
July 8, 2005: 5:22 PM EDT
by Katie Benner, CNN/Money staff writer
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NEW YORK (CNN/Money) - There's been a lot of talk in financial markets lately about why long-term interest rates aren't rising as fast as short-term rates -- a situation Fed Chairman Alan Greenspan has called a "conundrum."

Economists have said that in this environment there's a chance that short-term Treasury yields could rise above long-term rates -- a so-called inverted yield curve -- which has preceded the nation's last two recessions.

This week Cantor Fitzgerald, one of the world's top Treasury bond brokers, renewed recession worries by being one of the first to formally predict an inversion in the curve, saying there was a 20 percent chance that would happen by year-end.

The yield curve refers to the upward sloping graph that's normally depicted by bond yields in the Treasury market: the yields on shorter-maturity debt are lower than those on longer maturities. (Confused about yield curves? Click here for help.)

But while Cantor made the prediction Wednesday, on Friday it listed five economic and political factors that would probably prevent the curve from inverting.

For example, Cantor said the yield curve won't invert if the Federal Reserve stops hiking the overnight lending rate at 3.75 percent because higher overnight lending rates are the main factor behind the rise in short-term yields.

Or if real GDP growth hits 4 percent and 235,000 jobs are added to monthly payrolls for the rest of the year, driven by a new wave of corporate business spending, it would imply that inflationary pressures were increasing, the Cantor report said. That would tend to hurt bond prices and drive long-term rates higher as bond investors bet rates would rise further.

A slowdown in U.S. bond purchases by foreign central banks and a pickup in global inflationary pressures could also prevent an inversion, the report said, by pushing yields on the 10-year note higher as prices fell. Bond prices and yields move in opposite directions.

And a revaluation of the Chinese yuan could mean slowing growth of Chinese exports to the U.S. and less Treasury debt buying on the part of the Chinese government. This loss would put downward pressure on bond prices, sending yields higher.

John Herrmann, director of economic commentary for Cantor Viewpoint, a unit of Cantor Fitzgerald, said a modified version of each of these factors could also stop an inversion.

For example, while few economists are forecasting 235,000 new jobs a month, some believe that job growth will pick up.

"I really see the curve flattening by the end of the year, rather than inverting," Herrmann said in an interview.

Fear factor

The recent terror attacks in London increase the chances that global inflationary pressures could rise, he said. (For more on the London attacks click here.)

After the blasts that ripped through London, the European Central Bank and the Bank of England held interest rates steady, saying they were satisfied that financial markets were functioning and that no emergency injections of liquidity were necessary. (Full story.)

But rising oil prices and political pressures have lately forced the ECB to consider a rate cut to boost faltering growth. Analysts said that if shaky consumer sentiment is hurt by the explosions, a rate cut seems more likely.

"Globally, the U.S. and some emerging markets are the leading growth engines, so world inflation pressures have been limited," said Herrmann. "A rate cut in Europe would lift inflation pressures worldwide and the 10-year Treasury may sell off and push the yield comfortably above 4 percent," he added.

If a sell-off in the 10-year does occur, Herrmann said, it's unlikely the two-year yield will end the year higher than the 10-year yield, as Cantor had said was possible earlier this week. (Full story.)

Moreover, Herrmann said worries that foreign central banks are dramatically cutting back on Treasury buying are overblown.

"Treasury buying in the first five months of 2005 was down sharply year-on-year for net new purchases... but that is also a reflection of unusually aggressive buying in 2004 as other economies tried to prop up the dollar," he said.

Rather than portending recession, Herrmann said a flat curve reflects slow economic growth in Europe and Japan, particularly in relation to stronger U.S. growth, as investors worldwide have been snapping up long-term Treasuries as a flight to quality.

"Links between global economies are stronger now, and the flat curve reflects that," Herrmann said.

To find out why Cantor predicted an inverted curve, click here.

For more on the yield curve, click here.

To see what bonds are doing today, click here.

And click here for bond charts.  Top of page

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