Sigh, Yield Curve Still Inverted

Stock prices and the Treasury yield curve are two of the 10 designated leading economic indicators. However, what’s an investor to do when they’re predicting different outcomes?

The Dow Jones Industrial Average has touched its all-time high. Corporate profits stood at a 40-year high as a share of gross domestic product in the first and second quarters of 2006. With a good chance that second-quarter profits, at 12% of GDP, will be revised down based on upward revisions to personal income, it would be premature to conclude that the era of big margins is over and stock prices are just reflecting the optimism.

Then what is the reason of bond market being so gloomy? Long-term rates have been consistently below the federal funds rate for three months, an indication of bad economic times. The housing sector is past its prime. Corporate profits remain the dazzling spot of the growth and expansion. According to the Bureau of Economic Analysis (BEA), corporate profits increased 18.5% in the second quarter from a year earlier. Statistics show that since the fourth quarter of 2001, corporate profits have doubled while nominal GDP is up 29%. Profits for non-financial corporations decreased by 3.6% in the second quarter from the first. It was the first decline since the first quarter of 2003, excluding the Hurricane Katrina-related drop in the third quarter of 2005.

If the inverted yield curve persists for several more months, it would strengthen the idea of recession next year. The Fed is unlikely to cut rates in the next few months and an increase in long-term rates still remains a forecast. Many analysts dismiss the yield curve signal. They claim that it’s different this time. Asian central banks, recycling dollars into safe-haven Treasuries, it’s still a case of more entities wanting to save at any interest rate than they did before. And that’s not stimulative.