Tuesday, May 31, 2005

Bloomberg.com: Bloomberg Columnists

A good primer on the yield curve is posted at Bloomberg. One of the things not well understood is that higher short rates are used to lower long rates. In a run away economy it may take a while for the Fed to "get on top" of the curve but the point of raising short rates is actually to lower long rates.

One might fuss with me and say the point of raising short rate is to lower inflation, but the long rate is set by the market as a forecast of economic growth and inflation. A rise in short rates sometimes slows the economy, sometimes slows inflation and sometimes slows both.

Now-a-days, it is important to be aware that the curve is an international yield curve. We live in a global society. The yield curve in Europe is ready to take on a positive slope as central banks begin to lower short rates. This is analogous to taking ones foot off the brake and applying a little gas through the accelerator. Long-rates will be free to rise as the speed of the economy picks up. The US curve should not be far behind.

JP Morgan suggests zero growth in the US. The flat yield curve is suggesting slow growth; however, my forecast is that the curve is about to shift. The pressure is coming off Chairman Greenspan. The European economy is so slow that short rates are coming down. Greenspan can take his foot off the brake without letting inflation get out of control. When he lets off on the brake, long rates will trend up. It is even possible that he has had his hit the brakes too hard. If so, he may even have to cut short rates. In 1984 and again in 1994, the US economy was in a similar position. When the Fed eased up, the stock market caught fire.

Ironically, it is possible that it is the European market that leads the way this time. Germany appears likely to elect a Chancellor who is pro American! France is ready to boot out the current administration. The market may recognize that the No vote is a yes vote to capitalism.