It seems like we’ve been fighting over the yield curve for close to two years.  Sure it’s one of the most powerful graphs in economics.  But its magical power to predict a recession is what everyone has been talking about since at least January 2006 when the dreaded inverted yield curve began rearing its ugly, gnarly head.  This is not exactly your friendly every day Punksatony Phil type of prediction.

There have only been two instances in the last 50 years when the negative yield has not accurately predicted recession, making it the best predictor of recession ever.  It doesn’t cause recessions mind you, just predicts them.

The reasoning is really quite simple; banks make money by taking your deposits and lending them out to people who will pay higher interest rates than the bank is paying you.  As the yield curve flattens, banks can’t make money doing that anymore.   So they stop lending, which tends to slow business and personal investment down, which slows down the growth of the economy.

So the pundits have been arguing; will the magic of the curve hold true?  My argument has remained steadfast; the economy may slow down as it readjusts to money contractions, but recession would be very difficult given current government spending on the War and Katrina.  There’s just too many dollars being spent out there for the economy to tank.

And so far I’ve been right; we haven’t had a recession yet.  But there is a huge fly in the ointment; all the adjustable rate and sub-prime mortgages out there beginning to default because interest rates are rising and folks can’t afford to pay for their houses anymore.  Won’t that send the economy into oblivion?  Well, not really:

The downturn in the US housing sector, which has sparked market jitters, is of serious concern but poses no major risk of an overall US financial meltdown, the ratings agency Moody’s said Wednesday.

Moody’s has a heavy duty reference on their side:

 “US Federal Reserve Chairman Ben Bernanke said last week that he expected “significant financial losses” from failed sub-prime real estate loans but only a limited effect on the economy.”

I’m somewhat surprised that even Bernanke is downplaying the ultimate effect of the sub-prime storm that has yet to reach full gale.  Because it’s going to get uglier before it gets better.

It seems we’re weathering the storm ok though, and by 2008 should be seeing solid growth again.  So for those of you waiting for some huge tsunami of collapse reminiscent of the S&L crisis some years ago, well, that isn’t going to happen.  The world isn’t built like that anymore.  More importantly, the banks aren’t built like that anymore; they’re diversified, riskified, derivafied and webified.  They’re so technified nobody knows where the risk is anymore.  So it seems the magic of the inverted yield curve will fail again, but only for the third time in fifty or sixty years; still a great run.  And this will be the second time that it was government spending that put the lie to the rule, so I don’t like to think that counts.

Now, it does mean that you should add your banker to the list of people you can’t trust anymore; chances are his morals can no longer be distinguished from the used car salesman down the street.  Enforcing the meaning of fiduciary duty (please no more laws) would give mortgage bankers the slap upside the head they’ve been asking for. 

And it doesn’t mean that the dollar will stop sliding, and sliding.  The illness of our dollar is far more structural and pathological than a bunch of greedy, amoral bankers; all they’ve done is screw up the housing industry and make life immeasurably more difficult for thousands of hard working folks who didn’t know what they were signing.  No, the dollar symptoms bear witness to a chronic sickness about to be worsened by a decade long triple inflation wave front of commodities, food and energy.  It’s going to be quite a sickbed for awhile, and there aren’t any doctors in sight.  So grab your Maker’s Mark, or Nyquil, or whatever your favorite tonic is, because we’re in for a ten year ride here.

But we’ll leave those thoughts for another article.