Federal Reserve Chairman Alan Greenspan said while he considers the shape of the yield curve to be a significant economic indicator, it must be interpreted with some care. "In particular, a flattening of the yield curve is not a foolproof indicator of future economic weakness." In the past, a distribution of yields that produces a flatter yield curve often has been associated with an economic downturn but Greenspan noted that was not the case invariably. "For example, the yield curve narrowed sharply over the period 1992-94 even as the economy was entering the longest sustained expansion of the postwar period," he said.
An inverted yield curve, where the US Treasury's 10-year yield falls below the 2-year yield, was last seen in December 2000, and its appearance has predicted each of the past four US recessions. The debate now is whether another slowdown is looming. The US bond market is squarely focused on the US housing market, the key driver for the US economy, which created 58% of household wealth over the past four years. New US home sales fell 11.3% in November, and applications for mortgages fell to a 3 1/2 year low last week.
However, the powerful rallies in global stock markets and key industrial commodities point to another strong year of global economic growth of 4% or more, led by Asia. Most likely, the inverted yield curve has been distorted by the irrational buying habits of foreign central banks. Foreign holdings of Treasury securities was $2.07 trillion in September, or 50% of debt outstanding compared with only 18% eleven years ago. However, Japan was a net seller of $10 billion of US Treasury bonds in the 12 months thru October 2005, and on January 5th, China hinted it would diversify some of its $555 billion US dollar reserves into other foreign currencies "to improve the currency structure and asset structure of our foreign exchange reserves and to expand investments in other areas." Chinese sales of US bonds could restore the yield curve to a more normal shape.