In Berson’s weekly article Is the shape of the yield curve telling us that there will be a recession in 2007? [Fannie Mae] he explores the inverted yield curve. A flat or inverted yield curve has been a hot topic as of late because historically it has been a warning sign that the economy could be headed towards recession. Typically the yield for shorter term securities is lower than long term securities. The Fed’s measured growth action has caused short term borrowing costs (such as adjustable rate mortgages) but at the same time, long bond investors are comfortable that the Fed is keeping inflation in check, or as a few people have suggested, risk has not been adequately reflected by the market in the current low level of rates (ie fixed mortgages).

So will it be different this time? Is the Goldilocks [Matrix] scenario “not too hot, not too cold” unraveling?

Lets play _what if_

Popular opinion seems to be that an inverted yield curve is a non-event this time. Berson makes the following points:

  • First, not all yield curve inversions have been followed by a recession (although all modern recessions have been preceded by yield curve inversions). The yield curve inverted for 15 consecutive months from late-1965 to early-1967 without a subsequent downturn. (Note that the yield curve inverted again beginning in 1968, and the 1969-70 recession followed).

  • Second, long-term Treasury rates may be held down by special factors today. Among these factors are continued unprecedented foreign demand for U.S. dollar financial assets, relative supply shortages of longer-dated Treasury securities, and continued low inflation expectations.

  • Third, past yield curve inversions preceding recessions have been longer lasting, more severe, and more complete (that is, the yield curve inverted over its entire length) than the current episode.

But what does this mean to housing?

Quite a lot actually. With the White House experts jumping on the “soft landing” bandwagon [Yahoo/AP] there is rising concern that housing will determine our economic fate over the next few years. Its not just speculation anymore. A recession spells the end for housing as a powerful economic engine with higher borrowing costs and rising unemployment as the economy cools down.

However, the coverage of this latest release of information by the White House Council of Economic Advisers is confusing because it also paints a fairly rosey picture of the economy [Reuters] which means that inflation will become a threat and Bernanke will be forced to continue raising rates.

Yet GDP is expected to decline over the year – Fannie Mae has revised its projections downward. The Mortgage Bankers Association [pdf] forecast falling GDP throughout 2006. The 1.1% growth rate seen in 4Q 05 is largely felt to be an anomaly. MBA forcasts 2006 to see 4.4%, 3.5%, 3.1% and 3.0% GDP growth over each of the quarters in 2006, clearly an expectation that the economy will weaken.

This may cause the Fed to actually lower rates in 2007 to prime the pump, which may jump start housing market all over again.

Its enough to make your head spin.


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