Yield Curve Inversion

The yield curve inverts when short maturities sport yields
above those of longer dated maturities. We have seen yield
curve inversion in the US Treasury market on a day to day
basis since late in 2005.

Historically, an inverted yield curve has been a good
indicator of an impending sharp economic slowdown or
even recession. That's because yield curve inversion is
normally a symptom of either a liquidity squeeze or a
developing credit crunch wherein banks severely restrict
shorter term lending.

We have no squeeze or crunch now. Far from it. The
broad money aggregate M-3 is up 8.4% yr/yr, commercial
and industrial loans are up 15.5% yr/yr and trending higher,
and real estate loans continue to grow. In fact, the
financial sector is generating excess liquidity
now, or more liquidity than the economy actually needs.

Now, if the Fed Funds rate gets put up above 5.25% I'd wager
that banks will begin to take notice, and may well begin to start
to ration credit modestly. M-3 growth would slow because
funding requirements would slow, and the economy would
enter the very early stage of a liquidity squeeze. Bond
yields could even go lower in such an environment because
bond players would begin to anticipate eventual recession,
lower inflation and a flight to quality.

I'm strictly guessing the Fed may cut off the push on the
FFR at 5.0-5.25% in the months ahead, up from the current
4.5% posting. I doubt the Fed wants to become a centerpiece
political issue in a critical off-election year such as is
2006.

What might be of interest is how the bond market behaves
if the Fed goes to a FFR 5.0% and signals it may well
stay there for a while. That might send bond yields
sharply higher since some players would likely conclude
they may as well shorten maturities.

Note as well that following Uncle Al's silly roller coaster
ride with Fed credit post-Katrina, the FOMC is again adding
to holdongs, thereby signalling another bit of easing.