We Need Some Magic

Several people have questioned about the possibility of an inverted yield curve in the near future. Before I explain anything, I would like to note that Mr. Greenspan expressed his belief that the yield curve (this time around) does not necessarily signal a dismal economic outlook. As I have previously pointed out in my RW Wentworth newsletters, foreign entities purchasing longer term Treasuries may explain Greenspan’s conundrum.

Many, including myself, explained that Asian institutions have spent their excess dollar holding by buying U.S. Treasuries. Excess demand for existing Treasuries (i.e. 10 year) will raise prices, thus driving their yields down. So is there someone else that may be buying these Treasuries to further drive the rates down and invert the yield curve?

In light of these rising crude oil prices and speaking with other analysts, I believe that there may be new Treasury buyers. My previous post with the diagram of the gas price breakdown indicates that over 40% of the price we pay gas stations goes to crude oil producers. Since Katrina, we have seen gas prices jump all throughout the U.S. This would mean that more money goes to the crude oil producers for the same amount of oil.

If these “petrodollars” get funneled back into the U.S. in the form of Treasury purchases, then we could see the longer term Treasury yields remain in their already low levels. If oil prices continue to rise, and if these petrodollars make their way into our system, we may even see long term yield fall below the shorter term yields (i.e. 2 year).

The shorter term yields will most likely be impacted by the Fed’s decisions on the fed fund rates. As I have mentioned in my previous posts, the fed fund futures now indicate that the Federal Reserve is less likely to make many more hikes by the year's end. We are in no doubt dealing with a delicate situation.

To answer whether the yield curve could invert by the year end… I think it’s a definite possibility, but a flat or humped curve is more likely. However, I wouldn’t be surprised to see a slight inversion before the year comes to an end. Keep in mind that a yield curve doesn’t necessarily indicate a recession up ahead. We saw a flat yield curve before Katrina made her devastating path through our country. However, it appears that she came with her hammer and nails, not to help rebuild, but to shut the coffin. Let’s just hope it won’t be too bad… perhaps David Blaine, the street magician, could explain how he survived for a week buried alive in his temporary coffin.