Fed's easy policy hampers recession forecast tool

NEW YORK Wed Oct 12, 2011 2:42pm EDT

NEW YORK (Reuters) - Add the U.S. Treasury yield curve to the litany of items that the Federal Reserve's ultra loose monetary policy has turned topsy-turvy, and some economists who rely on it are none too happy.

The yield curve, or the difference between short- and long-term Treasury bond yields, has long been considered to be a key tool for forecasting recessions.

In recent history, a drop in longer-term yields below shorter rates has proceeded a recession.

But the extraordinary circumstances surrounding the Fed's efforts to stimulate the economy, including its near-zero interest rate policy, may make an inversion of the yield curve almost impossible.

"The yield curve is one of the most reliable predictors of changes to the business cycle. Its predictive power has been extremely diluted. Now it is much less useful," said Lynn Reaser, chief economist for Point Loma Nazarene University at Fermanian Business & Economic Institute in San Diego.

Reaser is a long-time watcher of the yield curve. She was a chief economist at Bank of America (BAC.N) for a decade and a president of the National Association for Business Economics, a leading group of U.S. economists.

Fears of an economic recession have been weighing on financial markets, with investors worried high unemployment in the United States and Europe's deepening debt crisis will weaken the already unimpressive U.S. recovery.

At the moment, the yield curve is reflecting a weak U.S. economy, but not one at the brink of recession.

Other bond market indicators, however, such as negative yields on Treasury Inflation-Protected Securities, suggest traders expect U.S. economy to flat-line or even contract.

"The curve has been artificially manipulated with Fed activity. Even so, you can't ignore the signs it is telegraphing," said Sean Simko, senior portfolio manager at SEI Investments Co in Oaks, Pennsylvania.

"We are seeing slow growth, but we are not expecting a recession," Simko said.

On Wednesday, the spread between the interest rate on three-month U.S. Treasury bills and the yield on 10-year Treasury notes -- which the Fed often uses in its yield curve studies -- suggests traders expect the U.S. economy is growing at nearly 2.2 percent, about 1.5 percentage points below its long-term average, but nowhere near the recessionary threshold.

The spread between the three-month bill rate and the 10-year note yield widened on Wednesday to 221 basis points -- the most since late August. It has widened 50 basis points since about three weeks ago when it hit its flattest level since February 2008.

DEATH OF A PREDICTOR?

The Fed's own studies cite a yield curve inversion -- when the three-month Treasury bill rate is higher than the yield on the 10-year Treasury note -- has preceded the six recessions from the 1970 to 2001.

Based on the Fed's definition, the yield curve inverted from July 2006 to April 2007, or seven months before the most recent recession began.

During the "Great Recession" from 2007-09, the Fed manipulated the yield curve -- first by dropping short-term rates near zero in December 2008 to combat the global financial crisis, then by a series of bond purchases in a bid to help the economy.

The U.S. central bank initiated its latest such purchase program last week. Dubbed "Operation Twist," it involves selling $400 billion of short-dated Treasuries the Fed owns and using the proceeds to buy long-dated issues in an attempt to force long-term borrowing costs lower and stimulate lending.

Despite the Fed's manhandling, the U.S. yield curve still has its fans.

The Conference Board includes the yield curve as one of the 10 components used to construct its U.S. leading indicator index. The group stands by its use of the yield curve for the index, despite the Fed's various bond schemes.

As long as longer-term Treasury yields stay above shorter-term interest rates, U.S. economic growth will likely remain in positive territory, says Ken Goldstein, an economist with the Conference Board.

"The fact we have a secular decline in long-term rates is positive," he said of the flattening of the yield curve.

But Goldstein said while the yield curve has been a positive factor for its leading economic index, it has been more than offset by high unemployment and weak spending.

"The problem is that no one is borrowing," he said. "We've never been here before."

While economists may gripe about the yield curve's diminished predictive quality, they warned against ignoring it entirely.

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