As we approach a new year, many economic commentators are spreading fear about the flat, or even inverted, yield curve. They claim it's a sign of recession just ahead. The yield curve is a graphical depiction of interest rates on bonds of different maturities. Normally, longer-term bonds have higher yields than short-term debt instruments because of inflationary expectations and because more risk and uncertainty are to be found over longer periods of time. It's true, an inverted yield curve often is a warning sign of recession. But only when other real-time market indicators, like commodity prices, confirm it.
In the late 1990s and early 00s, the yield curve was for long stretches inverted -- higher short term rates than long term rates -- and commodity prices were at two-decade lows, and the dollar was super-strong in the foreign exchange markets, and corporate profits were flat to falling, and the real Fed Funds rate was historically very high. These indicators were unanimous in their signal that monetary policy was far too tight, indeed deflationary. The result was the stock crash of 2000-2002, the recession of 2001, record corporate defaults, and the severe technology/telecom meltdown.
Today, none of these other indicators confirm the yield curve's so-far brief inversion. Commodity prices are at two-decade highs. The real Fed Funds rate, although it has risen consistently for the past two years, is still a bit below "neutral." Corporate profits are at record highs. The dollar has been weak, though it has been met by recent weakness in the euro -- in other words, the dollar hasn't really strengthened this year; the euro has weakened this year, while the dollar did most of its weakening in 2003-04. All these important data points say long-term rates will probably move higher as the broader market figures out that the Fed is in inflationary territory even though big inflation has not yet shown up much in the backwards looking Consumer Price Index.
The greater risk of recession will come in 2007, after the Fed feels compelled to really ratchet up rates because it missed the inflationary indicators of 2004-05 and left interest rates at 1% for too long. Right now, however, 2006 is looking pretty good.