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Is an Inverted Yield Curve in the Cards?

It's a rare phenomena when long-term interest rates exceed short-term rates. But at least one New York economist believes that scenario may be in the cards.

John Herrmann, chief economist at Cantor Viewpoint, a unit of Cantor Fitzgerald, said in a recent commentary note that since 1980, the U.S. Treasury market has seen six periods of yield curve inversions between two-year Treasury Notes and the 10-year Treasury Note. The most recent was in 2000, but the other five all occurred during the 1980s.

The length in time of the duration of each yield curve period ranged from nine weeks to 59 weeks, with the average falling around 30 weeks. That excludes a brief yield curve inversion in July of 1998.

Mr. Herrmann's outlook is somewhat contrarian. Most economists expect rates to rise as the economy strengthens. But Mr. Herrmann told MSN that mortgage rates could be headed lower - perhaps to 5.25% by the end of the year and eventually "grinding down to 5%" next year.

A deceleration of economic growth, competitive pressure in the mortgage industry, and a trend toward tying 30-year mortgage rates and hybrid loan rates closer to the five-year Treasury rate than the 10-year are all contributing factors, he said.

His reasoning? Without housing, economic growth is way below potential.

More typical of an economic expansion is a "steep" yield curve, with the longer-term Treasury notes exceeding short-term rates by an average of 89 basis points during the growth periods that dominated the economy from 1982 to 1990 and from 1991 to 2000. Since 2002, the yield curve has averaged a spread of almost 173 basis points, though currently it has fallen to near 30 basis points.

Mr. Herrmann said the Federal Reserve Board's aggressive anti-inflation stance has played a key role in each inversion period in recent history.

"It is clear that each such episode of the yield curve inversion was accompanied by a period of aggressive Fed tightening, or an overshoot of the Fed's 'neutral' target rate," he wrote.

And the Fed is in just such a period of "measured" increases in short-term rates today. Usually, yield-curve expansion occurs at the end of a business cycle expansion, Mr. Hermann said, rather than during the middle of one.

However, a midcycle risk of yield-curve inversion does exist today because of the Fed's vigilance in propping up the two-year Note rate while at the same time "special factors" are anchoring the 10-year Note to a lower rate than might be expected at this point in an expansion. Those special factors include the booming housing economy. If subtracted from the economy, the U.S. economy is only averaging growth of near 3% and non-farm payroll growth would also be much slower than currently is the case.

"Headwinds" from higher energy prices and the Fed's vigilance will slow economic growth to about that 3% level next year, causing core inflationary pressure to dissipate, he believes.

As such, an inverted yield curve could emerge as the natural consequence of the Fed's continued determination to head off inflation by raising short-term rates and the slowdown in economic growth Mr. Hermann anticipates for next year, he said.

Mr. Hermann said he believes there is a 20% to 35% chance that the yield curve will become inverted later this year or early next year.

"I don't think that implies an economic recession," he said. "It's consistent with a deceleration of GDP growth to around 3%, which is below the 5% potential growth of the economy." (c) 2005 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com