Every economic cycle goes through its own ups and downs. They’re as natural as sunrise and sunset.

This 25-Year weekly chart of the short-term yield to long-term yield ratio shows the bond market’s expectation of the cyclical economic activities. When the gap between the short-term and the long-term yields narrowed or flattened, bond market’s telling its investors that the future economic activities are slowing down. When this gap widens, higher economic activities are expected. And, if the curve’s inverted, then a recession is in the forecast.

This is clearly illustrated by the flat yield curve of Nov. 1989 (see also blue circles). That led to the recession of 1991-1992. When a steep yield curve developed toward the end of 1992. Bond market started looking forward to a more active economy. This by all means led to a nice period of economic expansion during the mid to late 90’s.

And as normal as sunrise and sunset, after the expansion of the 90's, we got into a recession in 2001 when the yield curve started flattening again. In early 2002, the bond market again was looking forward to a more active economy as the gap between the short-term and the long-term bond yields started to widen. Everything’s as normal as sunrise and sunset.

What came after that was anything but normal. While the chart still shows a steep yield curve in May 2003, the long-term yield had dropped below 5% and the short-term yield dropped to a inflation adjusted negative territory. Bond market was saying that it did not see any pickup on the economic activities in the future. So, what happened here was nothing but the Fed's easy money policy induced economic "recovery”.

Now, not only that we didn’t have a real economic recovery, but we’re also getting close to yet another yield curve flattening cycle, which means an economic slowdown. Come to think of it, we actually had never gotten out of the last recession. The Fed’s super liquidity had extended our “parole” period.

That extension, courtesy of the Federal Reserve, is going to do us all in.

© 2005 David Yu
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David Yu
Walnut Creek, CA USA
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