Daniel Gross writes about the inverted yield curve:
The Dread "Inverted Yield Curve" - It makes brave economists cower. By Daniel Gross : On Tuesday, the placid post-Christmas markets were rattled by news that interest rates on two-year bonds nudged higher than those for 10-year bonds. This was the dreaded inversion of the yield curve, and it sent the markets running. Why? Traditionally, inverted yield curves signal bad news for the economy--and hence for stocks... "this is a warning signal... that we are on recession watch now." Recession watch? You don't have to be a jolly optimist to believe that was an overreaction.... [T]he inversion thesis will likely be disproved in 2006. Just because a portion of the yield curve inverts, it doesn't mean the economy is poised to make like the S.S. Poseidon...
Usually an inverted yield curve is the result of a lot of domestic investors' thinking the Fed is going to cut short-term interest rates over the next couple of years, and so buying medium- and long-term bonds to lock in higher yields and reap hoped-for capital gains as interest rates fall. What makes the Fed cut short-term interest rates? A recession.
This inversion of the yield curve, however, is generated not by domestic investors' thinking that a recession is on the way, but by foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating.
Thus while an inverted yield curve is usually a sign that a bunch of people are trading bonds on their belief that a recession is likely, that is not what is going on in this case.