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US Interest Rates - The Effect of Globalisation on the Inverted Yield Curve

Interest-Rates / Analysis & Strategy Feb 27, 2007 - 02:53 PM GMT

By: Hans_Wagner

Interest-Rates

The inverted yield curve has been a good predictor of a recession in our economy according to several studies. Many investors seeking to beat the market consider the inverted yield curve a good indicator of economic problems in the future. They reason that long-term investors will settle for lower yields now if they expect the growth of the economy to slow or go negative in the future. I have been concerned that the inverted yield curve was an important indicator of a recession in the U.S. that would begin later this year.

However, so far the forecast recession has yet to show itself. Could it be that the global economy is negating the impact of the U.S. inverted yield curve? Let's take a look at this idea.


The U.S. yield curve inverted in early 2006 as the Federal Reserve raised the discount rate. Long term rates were under pressure from a slowing economy, low inflation and strong demand for Treasury securities from Asia and the Middle East. Even though the Federal Open Market Committee (FOMC) ended its current tightening in June 2006, the yield curve remains moderately inverted due primarily to the factors just mentioned.

Based on the past accuracy of the inverted yield curve predicating a recession, many investors believe a recession is near and corporate profits will deteriorate. Many economies throughout the world depend on the U.S. economy and consumer. The thought is if the U.S. slows down, then many of the world's global economies will weaken. If global profits have peaked for the current cycle, many investors believe they should reduce their exposure to these markets as well.

While we have seen a decline in the housing market and other signs of economic distress, the U.S. economy still is growing and corporate profits continue to grow though at a slower pace for the 4 th quarter 2006 than earlier. While it is important to be cognizant of this slow down, it is also important to not make a premature change in one's thinking about the economy and the market, as it seems to remain resilient.

Globalization has encouraged capital to flow more freely than ever before. This means we need to understand the implications of the global economy on the U.S. economy and the yield curve. Growing S&P 500 international revenue exposure (41% in 2005 vs. 32% in 2000), record cross-border M&A activity, and unprecedented outsourcing are but three examples of increasing global interdependence. Investors should therefore take the broadest possible view of the investment landscape. The sensitivity of U.S. multinationals to domestic interest rates has receded, thanks to their round-the-clock access to deep pools of global liquidity.

According to Alec Young of Standard & Poor's the GDP-weighted global yield curve is positive. Nine of the world's 11 largest economies have positive sloped yield curves. Investors throughout the world are looking for the best risk-adjusted returns then can receive. Their purchase of U.S. long term debt is a reflection of this investor interest. And the strength of the global economy helps explain why the U.S. inverted yield curve may not possess the same predictive power it did in the past.

While the economy maybe slowing down, many economists forecast 2.6% real U.S. GDP growth for 2007. Productivity continues to grow helping to keep inflation down. And profit growth is slowing, but still is expected to be positive for 2007.

Global economic activity is impacting countries in ways not fully understood, including the U.S. It is possible that the inverted yield curve in the U.S. is not as a significant factor as before. If so, then we will need to find ways to monitor economic activity in the world's economies, including the yield curve. This will be a new challenge for investors. From now on I will be including a review of a two or more countries yield curves as a part of my Weekly Commentary.

 

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/


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