ANNANDALE, Va. (MarketWatch) -- Little noticed in the wake of the Federal Reserve's rate cuts one week ago is how much steeper the yield curve has become.
That usually would be taken to mean that the risk of a recession has lessened. I think it is significant that it hasn't received more attention.
The yield curve, of course, refers to the difference between shorter-term and longer-term interest rates. Normally, shorter-term rates are lower. Now and then, however, the situation becomes reversed; on these relatively rare occasions, the yield curve is said to be "inverted."
An inverted yield curve is one of the leading economic indicators of an imminent recession. How likely? One answer is provided by a paper written a decade ago by Arturo Estrella, an economist at the Federal Reserve Bank of New York, and Frederic Mishkin, a Columbia University professor who joined the board of the Federal Reserve last year. They constructed an econometric model that, for various levels of the yield curve, calculates the probability of a recession occurring within 12 months. See article
According to their model, the probabilities of a recession grew to between 30% and 40% during 2006. According to that same model, those odds now stand at less than 10%.
Much of this decrease in odds occurred just one week ago. Shorter-term rates fell dramatically in the wake of the Fed's actions, while longer-term rates rose markedly. The net result was a much steeper yield curve.
I know, I know. It was just two weeks ago that I focused on the increased risk of recession that emerged from an analysis of the markets' reaction to the jobs data. See Sept. 12 column
But the difference between the yields on 90-day T-Bills and the 10-year T-Note (TNX:
![]()
TNX, , ) was less than half as big then. That translates into a significantly lower recession risk, and I wouldn't be doing you any favor if I failed to report this.
TNX
Sponsored by:
I should note in this regard that many of the bond-timing newsletters I track have failed to even mention the steepened yield curve, much less adjust their analyses because of it. This is revealing, from a contrarian perspective, since contrarians are suspicious of any consensus opinion that is stubbornly held in the face of evidence to the contrary.
This failure to make a big deal out of the steepening yield curve is also seen in the sanguine attitude that the bond timers have toward future interest-rate trends. I would have expected bond timers to become quite bearish in the face of the Fed's actions last week. But they didn't. Their current posture is instead best classified as merely neutral.
Consider the Hulbert Bond Newsletter Sentiment Index (HBNSI), which reflects the average recommended bond market exposure among a subset of short-term bond-timing newsletters tracked by the Hulbert Financial Digest. As of Tuesday night, the HBNSI stood at minus 5.3%, meaning that the editor of the average bond timing newsletter had only a modest short position on bonds and was otherwise in cash. I interpret this to mean that there is no panic among the bond-timing newsletters.
According to contrarians, long-term bonds are not likely to stage a sustainable rally (that is, long-term interest rates are not likely to decline significantly) until there is a lot more despair among the bond timers. 
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.