Is Iran the Cause of That Inverted Yield Curve?

Kevin A. Hassett, Bloomberg.com:

First, Bush administration officials puzzled over Americans' pessimism in the face of strong economic performance. Now the financial markets, which limped into the New Year, seem to be giving the president the same treatment.

In economic terms, 2005 was about as good as it gets. U.S. gross domestic product growth probably will come in between 3.5 and 4 percent. Job creation has been quite high, and the economy has weathered hurricanes and high energy prices well.

If anything, we learned in 2005 that the U.S. economy is even more resilient than we thought. According to Mark Zandi, chief economist at Economy.com, profit margins are “as high as they have ever been” and “the odds are high that the U.S. economy will enjoy a solid 2006.”

How have markets responded to all that good news? At least lately, long-term interest rates have headed south, and equity markets have gone along with them. Long rates have dipped so low--falling below short-term rates to produce the phenomenon known as an inverted yield curve--they might even be signaling a coming recession.

Economic Momentum

There are certainly economic stresses and strains. Higher interest rates may cause housing prices to tumble, bringing consumer spending along with it. The U.S. has troubling twin deficits that may put upward pressure on interest rates, magnifying that downdraft.

The problem is, the U.S. is carrying so much momentum into the New Year, it seems unlikely that these alone could push the economy into the kind of negative territory envisioned by the bond market. Indeed, corporate balance sheets are about as solid as they have been in memory, with debt loads relatively low and cash abundant. Higher interest rates should be a minor annoyance at best.

If we do sail through these problems, it will hardly be the first time. It has been almost 15 years since the U.S. economy shrunk for a full calendar year, back in 1991.

So if the economic data are not driving the bond market, what is? A brilliant new paper by Harvard economist Robert Barro may shed light on recent events. Barro, a lock for a future Nobel Prize, set out to evaluate the extent to which low-probability “disasters” have a significant impact on markets.

Barro's Findings

Economists have puzzled, for example, over why real returns on bonds have been so low relative to equities over recorded U.S. economic history. Interest rates have often been lower than economic theory predicts they should be, while equity returns have been higher.

Using data on rare negative events such as wars, Barro shows that economic models incorporating these rare events do a remarkable job matching the data.

If Barro is right, long-term rates may depend on low- probability geopolitical variables. And the effects may be enormous, perhaps even dwarfing the effects of traditional variables such as the deficit.

Barro clarified this connection in a recent interview: “A small increase in this kind of risk--as an example, due to the Sept. 11th events--leads to a noticeable response in real interest rates. When this probability goes up, the risk-free rate goes down because people put more of a premium on holding a relatively safe asset.”

What Futures Say

Given Barro's findings, one can't avoid the possibility that long interest rates have been moving down because of the flight to safety associated with heightened geopolitical risk.

To investigate whether there is anything going on that might have spooked markets, I headed over to the geopolitical futures markets. Academic work has found that these markets often provide the best possible estimate of the likelihood of future events.

Surprisingly, there has been a movement that is consistent with the Barro story. Intrade.com offers a futures contract that pays off if the U.S. or Israel bombs Iran between now and the end of March 2007. That probability has soared in recent weeks, and stood at a sobering 31.6 percent on Dec. 30. These low-volume markets should be interpreted with caution, but the probability, combined with recent outrageous statements by Iranian leaders, and the movements in bond markets, certainly give one pause.

Paradoxical Outlook

Of course, the problem may not be that markets are worried about the actions of Israel and the U.S. A bellicose and unpredictable Iran, potentially armed with nuclear weapons, could thrust the world down the kind of disastrous path studied by Barro. It might well be the case that the reality of a near- nuclear Iran is beginning to cause financial markets indigestion.

Iran, not Iraq, may be the big story of 2006, both politically and economically. READ MORE

If the economy is doing fine, but geopolitical risk is driving financial markets, then the economic outlook for 2006 may, perhaps paradoxically, have significantly more upside potential than many believe. First, the downside scenario is so terrible that diplomacy might well lead to a defusing of tensions on the nuclear issue. Barro has argued that small movements in these probabilities can be a big deal for financial markets.

Second, if nothing happens, we may experience an unusual confluence of economic events. Normally, when the economy has loads of momentum, long-term interest rates fly up, which then slows growth. A flight to safety because of uncertainties over Iran may mute that effect, allowing growth to be higher than it otherwise would be.

But even if GDP soars, financial markets might continue behaving in ways that defy the economic data unless stable and democratic governments take root in the Middle East.

Kevin A. Hassett is a resident scholar and director of economic policy studies at AEI.