Why that cheap home loan may signal trouble ahead

Economists are watching an unusual parity between short- and long-term interest rates.

By , Staff writer of The Christian Science Monitor

The bond market has been sending a signal of uncertainty about the economy - and raising concern in some quarters that the Federal Reserve may end up driving the economy into a slump.

The danger isn't imminent. But some economists say there's a pattern worth watching in bond prices, a phenomenon known as a flat "yield curve."

The Federal Reserve, with its ongoing moves toward tighter monetary policy, has been raising short-term interest rates steadily. Yet the interest, or yield, paid on long-term bonds hasn't risen as much. That has flattened the yield curve - a line that usually slopes upward as it shows the interest rates for debts with different time horizons (see chart).

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It's the kind of indicator only a statistician can love, but the shape of this chart can have implications for every business, borrower, and investor across America.

The current flat look itself isn't necessarily a problem, and this week the curve has gotten a bit steeper, as inflation worries have pushed long-term bond yields higher. But a number of bond watchers still worry that the yield curve could invert at some point - with short-term yields higher than long-term ones. Historically, that has forecast a recession.

"I wouldn't say the Fed has overdone it yet" with its interest-rate hikes, says Paul Kasriel, chief economist at Northern Trust in Chicago. But "we are in the zone now where the Fed's actions do increase the risks of a recession."

With its rate hikes, the Federal Reserve is trying to steer its policy toward a neutral position, where the economy can grow at its potential without fueling inflation.

But its effort inevitably revives debate: How far is far enough? "The Fed historically is not very good at not overdoing it," says Mr. Kasriel. He says paying closer attention to the yield curve might help.

In 2000, for example, the yield curve had a generally inverted shape for much of the year. The Fed didn't start lowering its short-term interest rate (the rate it charges banks for overnight loans), until the end of the year. A recession began in March 2001.

A kind of mini-inversion has emerged just recently. The Fed's yield on overnight loans is now higher than the yield on three-month Treasury bills, a pattern that emerged after last month's Fed rate hike.

John Park, an economist at Kudlow & Co. in New York, says this gap suggests that the bond traders may be less worried about inflation than the Fed, and more worried about economic growth.

Even with this week's uptick in Treasury yields, long-term interest rates remain well below where they were a year ago. Meanwhile, short-term rates have risen sharply.

"Long-term rates are still lower now than when the Fed started to tighten," says David Wyss, chief economist at Standard & Poor's in New York.

He is one of many economists who don't foresee an outright inversion of the yield curve. While it is flatter than a year ago, more than half a percentage point still separates short- and long-term rates.

The interest rate on a bond represents the cost of taking out a loan. It can be called the price of money.

Typically, the cost of borrowing rises as the time horizon expands, in part because of the added risks faced by lenders. That's why the interest-rate yield curve generally slopes gently upward from short-term to longer-term rates. An inversion generally signals the expectation that those short-term rates will soon plunge with a slowing economy.

With inversion still only a possible threat, the Fed for now seems most concerned with its perennial enemy No. 1: inflation. Concern about higher consumer prices has risen in recent weeks, fueled by post-hurricane energy costs.

For now, "the flattening yield curve actually represents an opportunity for consumers," says Greg McBride, a senior financial analyst at Bankrate.com.

Savers can earn much better yields on certificates of deposit than a year ago, without the risk of committing their money for more than a year or two. For borrowers, it may be a good time to lock in a fixed-rate loan, he says, since the flat curve means that those rates remain low.

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