What is an inverted yield curve indictating? Good times, bad times or something else? Statistically, it has been an fairly reliable indicator of coming recessions. Is this time different? It seems clear that the US will be going deeper in debt for some time. (Assumption 1) This implies that Treasury will issue ever more bond & notes annually. (Assuming US wants to avoid the "run-a-way" inflation that would result if the mint simply prints more money to meet the government's needs.) Treasury issues are subject to laws of supply and demand. Thus, if the demand is assumed to be constant, then assumption 1 implies the price of the all treasury notes & bonds will fall and interest rates will correspondingly rise. The demand could increase and then this need not be true or demand could decrease and then the drop in value and rise in interest rates would be even greater. Demand is not insensitive to time. For example if increasing inflation is expected, but not too bad at present, there can be great demand for short term notes yet little demand for bonds (Notes have no more than 5 years to maturity). A decreased demand for long term bonds will lower their price and increase interest rates at the "end" of the yield curve. This "normal" yield curve is also caused by the simple fact that money which will return many years hence is not as valuable as money which returns next year. Thus, the current purchase price of a $10,000 / 30 year bond will normally be less than the price of a $10,000 note and this "discount fact" does not indicate any increasing inflation expectation. It only indicates how much the future value of money is "discounted" to present value. In view of the above, the flat or inverted yield curve would seem to indicate that investors are not making even the normal discount of the future. Inversion would surely seem to imply that investors are not expecting inflation to increase significantly as this combines with the discount of the future to make the yield curve even steeper. Hence it seems safe to assume (Assumption 2) that investors are not currently expecting growing inflation, despite the growing US debt, which could normally cause significant inflation. Why might that be? Possible answers: (1) The Fed, under Greenspan, has demonstrated the ability to control inflation and more governments (even those like Brazil, where double digit monthly inflation was recently common) are now using "inflation targeting" policies. - Adjusting interest rates they can control, bank deposit requirements, etc., to limit inflation well below double digit annual rates. (2) The world is "flooded with money" because following the IT bubble burst of a few years ago, many central banks feared economic recession and greatly eased credit. This "excess liquidity" funded both record levels of Foreign Direct Investments, FDI, in China and other less developed countries (i.e. the BRICs, etc.) and sought shelter in Treasury bonds, driving the price up and interest rates down. In this view, it could be more that short term rates are high than that long term rates are low, which causes the relatively flat yield curve. (3) Many financial institutions, such as insurance companies, pension funds etc., have very foreseeable and distant financial needs, which they want and need to offset with long term stable assets, such as 30 year US bonds; however, for past three years no 30 years bonds have been issued. Only a decreasing supply of older issues were available in the secondary markets. This supply shortage, drove the price up and interest rates down at the long end of the curve. Some support for this view can be found in fact that the recent resumption of 30 bond sales was very popular and over subscribed. I think Asumptions 1 & 2 are both valid, but refute them if you can. Surely there are other ideas & explanations why, despite the rapid growth of the US's "twin deficits," the yield curve shape is not indicating that investor expect an inflation surge. I would like to hear them because, I am currently leaning towards: (4) This time is not different. Investors are wrong. Inflation is going to return and with it the high interest rates, which will crush the economy, especially the housing market, were many have withdraw their equity and spent it. I.e. once again the inverted yield curve is forecasting bad times ahead, despite the "rationalizations" of (1), (2) & (3) above. What do you think, and why?