Rising Rates?

Focus on Fed Policy

Recently all eyes have been on Fed policy regarding the possible tapering of bond purchases.  This preoccupation with Fed policy has led investors to liquidate bond mutual funds and ETF’s in record amounts.  This has led to a rapid rise in interest rates to the highest levels of the last two years.  Mortgage rates have soared to 4.5% during the last six weeks.  The chart below shows the rise in 30 year mortgage rates since the Fed announced it might start tapering bond purchases.  We feel investors are currently focused on the wrong thing, and the rise in rates has created a buying opportunity in bonds.

 

 

 What Drives Interest Rates

The two primary drivers of interest rates are the general level of economic growth, and inflationary expectations.  Fed policy is largely driven by these conditions and is very much “data dependent”.  The economy only grew at a 1.8% rate during the 1st Quarter of this year.  This is significantly below the long term economic growth trend.  The Fed has had a history of being overly optimistic about future growth  in the economy.  Forecasts of higher growth rates for the rest of the year strike us as being overly optimistic, considering the recent move higher in interest rates.  We expect higher rates to slow down the housing market and the economy in general during the rest of the year.  It is important to remember that stronger economic conditions for the rest of the year is not a known event.  We feel a continued period of weak growth is more likely.  Higher tax rates, higher mortgage rates, a slowdown in government expenditures, and negative demographics are all headwinds for the economy.  The debt limit ceiling will need to be raised by early fall to keep the government running.  There has been no talk of progress made in Congress regarding the two parties working together to address the budgetary issues facing the country.  Instead, both parties are becoming even more polarized.  It is hard to imagine this changing soon.  The potential for negative noise coming out of Washington concerning budget battles and the debt ceiling  may also be a drag on the economy.

 

The chart below shows the continued decline in inflationary expectations.  This trend is not indicative of rising rates.  In fact, it seems to be providing a green light for the bond market.  Many investors believe the expansion in the Fed’s balance sheet has to be inflationary at some point.  However, the data does not support this argument at this time.

 

 

The Fed’s QE Experiment

The Fed began Quantitative Easing (QE) during the financial crisis in 2008.  Quantitative Easing occurs when the Fed expands it’s balance sheet by purchasing assets such as U.S. Treasuries and Mortgage Backed Securities.  QE is supposed to be a monetary tool which is used when the Fed Funds rate is at or near zero and unemployment is high and the Fed believes more monetary easing is necessary.  QE is a tool to lower long term interest rates to stimulate economic growth. 

 

 

The chart above shows the last two rounds of QE have not been as effective in lowering interest rates as QE1 and QE2.  The diminishing returns of QE3 and QE4 cast a shadow of doubt concerning the effectiveness of continued QE.   Quantitative Easing has been tried in Japan with little success as the Japanese have been engaged in a 20 year battle against deflation. 

 

Stuck In A Liquidity Trap

The velocity of money, as shown in the chart below, has continued its downward trend.  This is a sign we are in a classic liquidity trap, and monetary tools are relatively ineffective in stimulating the economy. 

 

 

This has occurred because there is too much debt in our system, and demographic trends are very negative for the economy.  The Fed’s monetary tools are designed to encourage borrowing to stimulate economic activity.  This does not work well in a highly indebted economy. The large number of baby boomers and longer life expectancies have created a large group of older people in the U.S.  An aging population does not have enough consumers in the accumulation phase of life.  They are not borrowers and spenders.  Instead, there are more consumers who are spending less on things, and more on healthcare.  This is  very negative for economic growth because it dampens the effectiveness of monetary policy.

 

How High Should Rates Be Without Government Manipulation?

The question fixed income investors should be asking is “how high should rates be without the government trying to manipulate the market?”  We believe the current level of rates offers value to investors.  Inflation is running at about 1%.  The Fed has made every effort to get it higher without success.  Japan has been in a similar situation.  The 10 year JGB still yields less than 1% in Japan.  Our 10 year UST yields about 2.55%.  The German bund yields 1.58%, the rate in the UK is 2.34%, and is only 2.2% in France.  Corporate and Muni yields are higher still.  Long Munis for good BBB rated bonds yield over 5%.  This equates to taxable equivalent yields of 8-10%.  These are very attractive rates for retail investors. 

 

Conclusion

Investors should pay attention to the weak trend of economic growth and low inflationary expectations.  The recent selling of bond funds has created a good opportunity for investors to add to their fixed income positions at prices which have not been available for the last 2 years.

 

 

 

 

 

 

 

 

 

 

 

 

Nominal GDP and Inflation

The Current View of Inflation
Investors have become increasingly concerned about future inflation due to massive governmental intervention and growth in the money supply. These investors argue that the large increase in money supply has to go somewhere, and it will cause inflation. They may also argue that this increase in money will cause the dollar to go down, which will in turn cause prices to rise even further. They frequently feel compelled to throw in their thought that the deficits we are currently running are so large, that the only way out of this situation is to inflate our way out. This is currently the consensus view. While this view may be intuitively obvious to most investors, we believe high rates of inflation are not necessarily a foregone conclusion.

Review of Inflation
The chart below shows the annual rates of inflation as measured by the U.S. CPI Index for Urban Consumers on a non-seasonally adjusted basis since 1926 through 2008.

This information is available from the U.S. Department of Labor and may also be found in the Ibbotson SBBI 2009 Yearbook. The average annual rate of inflation during this time period was 3.0%. During the period from 1926-1933 we experienced deflation. In fact, it took until 1945 for the Consumer Price Index to get back to the level it was at in 1926. During the 1950’s and 1960’s inflation experienced a slow rise. The 1970’s saw inflation rise until it peaked at 13.3% in 1979. This was the year gold reached $850.00 per ounce and silver peaked out at $50.00 an ounce as Bunker Hunt tried to corner the silver market. WIN buttons were passed out which stood for “Whip Inflation Now”. OPEC proclaimed an oil embargo and the price of oil went shockingly high. This was an inflection point for inflation. During the 1980’s inflation steadily declined and this trend continued through the 1990’s until last summer when oil reached $150.00 a barrel. Since then the economy has continued to decline and price increases have been under control. Last year the CPI was only up 0.1% even though gas prices had reached prices of over $4.00 a gallon during the summer. Last summer many investors “knew” inflation had returned and feared interest rates were going higher. So far, during this year the index has increased 1.3% through April. The chart below shows the average annual inflation rate by decade since 1926. By looking at inflation over longer time periods the data is smoothed and we are able to see the long term trends more clearly.

Inflation and Economic Growth
Our research shows a high correlation between economic growth and inflation when the economy grows faster than trend. We used data from the Bureau of Economic Analysis to measure growth of GDP. GDP grew at an average annual nominal rate of 6.68% during the period from 1926-2008. Let’s call this the trend rate of growth for the economy in the U.S. In the chart below we compare the annual rate of growth of nominal GDP minus the trend rate by decade, and compare this growth versus trend to the CPI. The results show a high correlation. During the 1930’s the economy contracted below trend and we had deflation. During the 1940’s, 1970’s, and 1980’s the economy grew above trend and we had high levels of inflation. Economic growth during the the 1950’s and 1960’s was at trend and inflation was low. The last 20 years has shown growth below trend with declining rates of inflation.

Conclusion
Investors would be wise to pay attention to indicators which
are leading indicators of the economy such as the LEI Index or the Chicago Fed National Activity Index. These indicators are currently still showing economic weakness which is way below the trend rate for the economy of 6.68%. Inflationary pressures are not likely to appear until growth in nominal GDP approaches levels in excess of trend.

Inflation Worries

Investors are becoming increasingly concerned about inflation as a result of the massive governmental intervention which is taking place. Their argument is that “the government is running large deficits and the money supply is growing out of control”. They feel sooner or later we will experience inflation, and they are worried about a dramatic fall in the dollar and the possibility of hyper-inflation as a result. We feel inflation fears are currently overblown since the economy is still contracting and is very weak. The chart below shows the Chicago Fed National Activity Index. It is a combination of several leading indicators and shows how we are doing

compared to the long term trend growth rate of the economy which is represented by the line at 0. Inflationary warnings flash when this indicator is at 0.7%, and recession is likely to occur when the index falls below –0.7%. The current reading is about –3.4% which is nowhere near the inflationary warning level of 0.7%.


Most investors have grossly underestimated the deflationary forces at work in the economy due to deleveraging caused by tight money conditions in a highly leveraged economy. The cheap funding through the short-term markets which allowed leveraging to take place has disappeared, because the bond insurers are no longer AAA rated credits. This has reduced the supply of credit dramatically because the “borrow short and lend long” trades no longer work. These trades represented the “Shadow Banking System” which funded leveraged buy-outs, no money down housing loans, and hedge fund activity. The contraction of this form of financing has led to economic weakness, which has caused the velocity of money to fall, which has offset the increase in the money supply. It will most likely take a long period of time for these forces to work themselves out before inflation becomes a problem.

Pushing On A String?

Is The Fed Too Easy Or Too Tight?
There has been much talk recently about the need for the Fed to raise rates to stop rising global inflation. Our work shows that money is still tight, even though the Fed has lowered the Fed Funds rate to 2.00%. The Fed surveys senior bank loan officers about lending practices at banks. This information is gathered through the “Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices”. The Fed conducts this survey quarterly with about 60 large domestic banks, and 24 U.S. branches of foreign banks. The information from this survey is quite interesting in today’s environment. The chart below shows the availability of credit and the cost of credit as shown through the Fed’s survey. As you can see

the credit lending standards have become progressively more restrictive. This is shown by the blue line in the chart. As bank lending standards have grown stricter, the cost of credit has been climbing rapidly (shown by the red line). In fact, the percentage of senior bank lending officers who are raising credit costs to businesses is currently higher than at anytime since the survey began in June 1990. It is interesting that banks have been tightening credit during the same time that the Fed has been trying to ease credit conditions. The chart below shows the cost of borrowing plotted vs the Fed Funds rate during the same period of time (6/1990-6/2008).

The chart shows the expected lags in bank lending costs, but recent developments are an anomaly, since borrowing costs are soaring as the Fed continues to lower short term rates. This implies that the Fed is currently “pushing on a string”. The tool of using rates to control the economy is no longer working as it has in the past. This is an alarming development, because it shows the seriousness of the current credit crisis in the U.S.

The Party’s Over
Over the last few decades the Fed has gained enormous credibility as an institution with the ability to manage our economy out of recessions in a non-inflationary way. The Fed as lender of last resort created the “Greenspan Put”, which meant when things got bad the Fed would be there to make things better. This policy has not, however, been without costs, and has only postponed the inevitable. This led to an incredible leveraging of our financial system, the creation of the shadow banking system, and massive amounts of debt being accumulated by the consumer and guaranteed by our financial institutions. The lax lending standards and cheap credit shown in the first chart during 2005-2007 helped create the debt hangover we are currently suffering. Rising delinquency rates and massive write-down's of loans have created deteriorating balance sheets for our banks and investment banks. They want to forget about the lax credit party that got them where they are today. The Pushing On A String chart shows the party is over. Banks are in no position to party again any time soon. Their hangover is too great. We should expect them to concentrate on re-building balance sheets, by raising capital, deleveraging, and cutting back anyway they can. The thought that money is easy, because the Fed cut short term rates is a misconception. Money is tight and will remain tight until the financial system begins to recover from the excesses of a couple of years ago.

Is There More Inflation In The Future?

Inflation Outlook
Recently, there has been much talk in the press about inflation. The argument is made that the recent rise in food and energy prices has to filter into the inflation numbers sooner or later, and that interest rates have to rise because inflation is so bad. Frequently this argument is further editorialized with comments such as “I don’t know why the Fed only looks at core inflation. After all, don’t we all have to eat and drive to work? Of course, if you take out everything that goes up, we won’t have any inflation at all!”. This is commonly followed by snickers, as if they are the only ones who could figure this out.

We pay close attention to inflation, which is a lagging economic indicator. Studies show inflation tends to peak at about the same time the economy is bottoming. It has been our opinion that we are in a temporary cyclical upturn in inflation, and we should see inflation come down as the economy slows. The chart below is a Fed model (Chicago Fed National Activity Index)

which shows economic activity and the likelihood of increasing inflationary pressures. The blue line is the value of the index and is charted against the axis on the left. We have added an index of inflation to the graph. The gray area is a graph of the year over year Personal Consumption Expenditures Index. This is the Fed’s preferred measure for inflation and the axis on the right shows the inflation rates. The CFNAI uses 85 different economic indicators as inputs which measure:

1. Production and Income
2. Employment, Unemployment, Hours Worked
3. Personal Consumption and Housing
4. Sales, Orders, Inventories

The Fed model uses a 3 month moving average to smooth the data. The index is designed to be 0.0 when the economy is growing at the long term trend rate. The index is positive when the economy is growing rapidly, and is negative when it is growing slowly. When the index is below –0.70 it is increasingly likely we are in recession. The index has been below –0.70 for the last 5 months. The current value is –1.25. This suggests a continued weak economy in the future. When the index is above 0.7 after the economy has grown for more than 2 years it is likely inflation will rise. This model shows the strong correlation between the overall strength of the economy and inflation. Since the index is in negative territory, this model shows it is likely that inflation will moderate in the future.

Conclusion
Investors should not become distracted by the chatter in the press about the need for interest rates to rise because of inflation. High oil prices and inflation are certainly today's problem, but the leading indicators show inflation is likely to moderate in the future, because of the weak economy.

What Happened To Bonds?

During the last month, the bond market has weakened dramatically. This is particularly evident in maturities from 10-30 years. The 10 Yr Treasury yield went from 4.63% on May 8 to an intra-day high yield of 5.25% on Friday (6/8) before ending the day at 5.14%. The Treasury market has suddenly become big news, and dominates the talking heads on TV. Investors would do well to ignore the trader talk on TV about bonds, and concentrate on the long-term fundamentals for bonds.


The Fundamentals

The two most important determinants of bond yields are:
1. Inflation expectations
2. Strength/weakness of the economy

The Fed has been concerned about reining in inflation, and raised the Fed Funds rate from a low of 1.0% on 5/4/2004 to the current level of 5.25%. This target was established almost 1 Yr ago on 8/8/2006. Since then, they have been in a holding pattern as inflation has fallen from 2.4% to 2.0% on the core PCE price index. The Fed would like this measure to be within the 1-2% target band. We view the progress on inflation as a positive for bonds. There is no evidence that the recent decline in the bond market is linked to an increase in inflationary expectations. The economy has slowed from about a 2.5% growth rate in August of 2006 to a recent weak 0.6% for the 1st quarter of this year (while the Fed has been on hold). This slowing in the economy is also a positive for the bond markets. So, the economic fundamentals are still positive for bond investors.


The Technicals

Since the long-term fundamentals are still positive for bonds, the most likely explanation for the sharp rise in bond yields last month is to be found in short-term changes or the technicals that pre-occupy the minds of traders. Here are some of the technical developments of the last month:

1. The amount of 10 Yr Treasury securities purchased at the last quarterly refunding on 5/8 by Foreign Central Banks was the highest since November 2005. This appeared to be a positive technical development for the market. These bonds sold at 4.63% at the May auction.
2. Shortly after the auction, the Fed stated it was still concerned about inflation and began to raise doubts that it would ease rates soon. These doubts increased during the month as several hawkish comments were made by different Fed Governors. The chart below from a 6/8 Citigroup report shows the change in expectations for a Fed easing over differing time periods.


As recently as 4/18, the market was pricing in an easing of 75 bp’s this year. This probability has now declined to a 0.0% chance. We believe this change in perception is the primary catalyst for the sell-off this month.
3. There has been Foreign Central Bank tightening by the European Central Bank and the Bank of New Zealand, which has added to the change in psychology of bond traders. Their logic is, "how can the Fed ease when the rest of the world is raising rates?" Were we overly optimistic about the Fed cutting rates 75 bp’s this year?
4. Mortgage durations have been rising in lenders' portfolios as ARMS are replaced with longer fixed rate mortgages by borrowers. This has led to hedging activity by lenders such as FNMA, selling 10 Yr Treasury securities to help shorten the duration of their huge loan portfolios.
5. Traders who look at charts feel that the 20 year bond market rally has ended and are shorting bonds. This has contributed to the weakness in the market.
6. The yield curve has steepened significantly which has been caused by large curve flattening trades being liquidated and replaced by curve steepening trades. This is very plausible because during the time long term yields have risen, short term yields have fallen modestly. Since 3/2/2007, the yield curve has gone from being inverted by (60) bp’s to having a positive slope of 17 bp’s on 6/1/2007. To implement this trade, the trader sells the long bond and buys shorter maturity bonds. This has contributed to the recent rise in rates.


Conclusion

There have been several technical factors that have contributed to the recent rout taking place in the bond market. This has driven yields to attractive levels for investors. This is a good time to ignore the traders on TV. Traders frequently change their opinions and have different time horizons than the investor. These same traders were telling us less than 2 months ago that there was a high probability that we would see a 75 bp's cut in rates this year by the Fed. Now they think there is no chance for a cut in rates. Future actions by the Fed are data dependent. If inflation continues to slow and the economy stays weak, rates will fall. The recent rise in rates should have a dampening effect on the economy which could lead to lower rates in the future. We feel the current sale in the bond market represents an opportunity for investors to add to their fixed income positions.

Bonds: Probit Models Predict Probability Of Recession

There was much ado over Greenspan's recent comments that there is a 33% chance the U.S. economy will enter into a recession later this year. The Fed seemed to be caught off guard by these comments, and Bernanke testified before Congress that The Fed was still concerned about inflation and the economy is in good shape. Why would Greenspan make such remarks?

We believe it is highly likely that Greenspan's forecast is based on probit models designed by The Fed. For those of you who aren't familiar with a probit model, we will look at the following definitions of probit. Wikipedia's definition is: "In statistics, a probit model is a popular specification of a generalized linear model, using the probit link function. Probit models were introduced by Chester Ittner Bliss. Because the response is a series of binomial results, the likelihood is often assumed to follow the binomial distribution." About Economics defines probit as: "An econometric model in which the dependent variable yi can be only one or zero, and the continuous independent variable xi are estimated in:

Pr(yi=1)=F(xi'b)

Here b is a parameter to be estimated, and F is the normal cdf. The logit model is the same but with a different cdf for F."

For those who still don't know what a probit model is, let's just say it is an econometric forecasting model. Probit models have been used by The Fed to forecast recessions. These models are based on the slope of the yield curve and have been very reliable in forecasting periods of economic weakness. When the 90 day T-Bill yields more than the 10 Year treasury bond, the model views this as a negative development for the economy. The chart below shows the history of the 10 Yr vs. the 90 Day T-Bill for the last 20 years.


Jonathan Wright from the Federal Reserve Board's Division of Monetary Affairs developed a probit model that measures the spread between the 3 month T-Bill yield and the 10 Year Treasury yield. It also looks at the general level of Fed Funds. He has written a working paper entitled "The Yield Curve and Predicting Recessions" which compares 4 different versions of the model. He concludes that measuring the spread between the 3 month T-Bill and the 10 Year Treasury as well as including the level of Fed Funds is the best of the 4 approaches for predicting recessions. The results of the model are shown below. The number at the right is the probability of a recession and the red areas show periods of economic weakness. As you can see, this model has had a very close correlation when predicting periods of economic weakness in the past without giving false signals.


Griffin Kubik, a securities firm in Chicago, replicated this model. The model is currently saying there is a better than 50% chance of a recession in the next 4 Quarters. We have seen other models projecting as high as a 95% chance of recession. Some of these other models are based on the spread between the 1 Year T-Bill and the 10 Year, without factoring in the general level of interest rates. Wright enhanced these earlier models by including Fed Funds as a proxy for interest rates. It seems likely that Greenspan is using some variation of one of these types of probit models. Perhaps he has enhanced Wright's model with some other variable. Although each of these models project different probabilities for a recession, they all agree that the longer The Fed keeps the yield curve inverted, the greater the probability our economy will enter a recession by the end of the year. The chart below shows the current estimation of the probability of a recession using Wright's model. Remember the probability was only at 20% when the chart above was created.

Bonds: How Strong Is The Economy?

The Index of Leading Economic Indicators is showing potential economic weakness in the months ahead. The chart below shows the LEI for the last 15 years. The LEI peaked out in January 2006 at 139.1. The levels for February, which were just released, show a reading of 137.3. This index is a good indicator of economic strength over the next 4-6 months. The weakness in this indicator would suggest slower growth or weakness for the balance of 2007.

The LEI is composed of 10 different components. The different components are listed below with both their weighting in the index and their contribution to the last reading of LEI. The Conference Board releases this data about 3 weeks after the end of the previous month.

The largest contributors to the LEI are the Money Supply and the Factory Workweek. These 2 components account for about 60% of the value of the LEI. Recently, there has been much talk in the press about the housing market and whether the weakness in housing will drag down the rest of the economy. This sector of the economy is measured by Building Permits which accounts for only 2.7% of the LEI. However, most of the focus of economists and the press has been on housing. Now, their attention is moving to high defaults in sub-prime mortgages, and possible tightening of credit conditions for new home buyers.

Let's look at the LEI and some of the other components of the index. Last month, 5 of the 10 measures showed weakness in the economy. These measures were: the yield curve, vendor performance, initial jobless claims, consumer expectations, and building permits.

There is value in following the LEI and all of these components. The weakness in the index is not coming from only 1 sector of the economy (housing), but is shown in several of the individual measures of future economic growth. There are several economists calling for the economy to pick up later in the year. (These economists are obviously not paying attention to the LEI). We feel this is unlikely, and expect the economy to continue to slow. This should provide a favorable backdrop for bonds.

All data shown above is from the Conference Board which releases the Index of Leading Economic Indicators.

Bonds and the Fed

We have never had more confidence in the Fed and it's ability to manage the economy. Yet, the Fed has a history of creating excessive credit conditions, and then taking steps to remove these excesses. Tight money tends to cause distress first in the areas that are most overextended. The chart below is from David Rosenberg at Merrill Lynch. His theory is that when the Fed is in a tightening mode, they will continue reigning in credit until something bad happens. Then they will ease to counteract the damage they have just done, and the cycle repeats itself. Some of the most memorable examples from Merrill's chart are, the Tech Wreck, Long Term Capital, S&L Crisis, and Penn Square Bank. Many of these negative events were a result of the excessive credit conditions the Fed created in the first place. When they took steps to get the market to return to normalcy, "bad things happened."

One might ask why this pattern tends to repeat itself? This is largely the result of the Fed trying to manage the economy. Their tool of choice is to control the process of "borrowing short and lending long". In essence, this is how our banking industry works, and it is a great system. When the Fed lowers short-term rates, they make the yield curve steeper. This allows banks to make a larger spread (profitability) and over time increases the amount of liquidity that is available in the credit markets. This increased availability of credit allows borrowers to have the funds that are necessary to make purchases, which in turn stimulates the economy. The reverse is also true when they raise short-term rates which drains liquidity from the system. Isn't it interesting that our system depends upon the borrowers to get it going and to slow it down?

After 9/11 there was a massive reduction in short-term rates which produced large amounts of liquidity and availability of credit. Much of this money went into the housing market. Many of those loans were financed with little or no money down, and many of the borrowers were sub-prime borrowers. It wasn't that long ago that the public and economists were thinking that higher rates wouldn't have that much of an impact on the housing market. Then they were saying that the housing slowdown wouldn't affect the economy and it would continue to grow, and activity would pick up later in the year. Now we are seeing high defaults in sub-prime mortgages by the people who couldn't afford the houses they were buying in the first place. So, will the sub-prime problem spread to the rest of the economy? That is the question being asked now. Shouldn't the question be: Why wouldn't we experience ripples across the credit markets? After all, the Fed has made money tight and we know from experience that they will continue in this mode until something bad happens.

Bonds: The Economy

The level of interest rates is driven largely by long term inflationary expectations and the growth rate of the economy. We monitor the GDP Core price index as a measure of inflation, and the Index of Leading Economic Indicators (LEI), looking for clues about future economic growth. The LEI consists of 10 different economic indicators.

Let's take a look at inflation. There has been much talk about inflation in the press. We believe we have experienced a cyclical upturn in inflation, but the long term secular trend in inflation is still lower. The response from the Fed during the last 2.5 years has increased our confidence in both their ability and their desire to control inflation. The chart below shows the GDP Personal Consumption Core Price Index from 1992 to 2006. Also graphed on the chart is a 13 quarter moving average, which shows the smoothing of the index over a three year period. Bernanke has said that he would like to see this index under 2% as an upper band. It is currently 1.9%.
Economic growth depends largely upon the availability of credit. A good measure of the tightness of credit is the slope of the yield curve. Our economy has had an inverted yield curve since last June. An inverted curve is like a tourniquet on the economy. The lifeblood of the economy is money, and the Fed is restricting the ability of different sectors to have access to credit. The economy is gradually showing signs of weakness as the restriction of the "blood flow" to the economy affects different "body parts" more quickly than others. The chart below is for the interest rate spread between a 10 year treasury and fed funds. It shows the dramatic change in the yield curve that has taken place since the Fed began tightening in June of 2004. Banks are in the business of borrowing "short" and lending "long". When the yield curve is inverse, the economic incentive for them to loan money is reduced because they can't make money off the trade of borrowing short and lending long. This also helps to restrict the availability of credit, and helps to dampen the economy.
Perhaps the first body part to experience distress was housing. The weakness in housing is illustrated by the rapid decline in building permits which began their decline in the last quarter of 2005.

New orders for consumer goods are also showing weakness. This component in the index of leading economic indicators is an inflation adjusted value of manufacturers new orders for consumer goods and materials, and is designed to lead changes in production. This index peaked out in the middle of 2004 when the Fed began tightening credit.
The weakness in housing is now spreading to sub-prime mortgages. There is weakness in risk assets such as domestic and foreign equities, and in commodities like gold and oil. The question being asked now is, "will this weakness spread to other areas of the credit markets?" The answer is clear. The economy will continue to slow until the Fed realizes that it is about to kill the patient, and then they will ease up on rates to try to get things going again. This is a very favorable environment for bonds. We believe that current bond rates are attractive, and investors who are still bearish should rethink their positions.