What’s a yield curve, and why is it so important?

Well, the curve itself measures Treasury interest rates, by maturity, from 91-day T-bills all the way out to 30-year bonds. It’s the difference between the long rates and the short rates that tells a key story about the future of the economy.

When the curve is wide and upward sloping, as it is today, it tells us that the economic future is good. When the curve is upside down, or inverted, with short rates above long rates, it tells us that something is amiss – such as a credit crunch and a recession.

The inverted curve is abnormal; the positive curve is normal. We have returned to normalcy, and then some. Right now, the difference between long and short Treasury rates is as wide as any time in history. With the Fed pumping in all that money and anchoring the short rate at zero, investors are now charging the Treasury a higher interest rate for buying its bonds. That’s as it should be. The time preference of money simply means that the investor will hold Treasury bonds for a longer period of time, but he or she is going to charge a higher rate. That is a normal risk profile.

The yield curve may be the best single forecasting predictor there is. When it was inverted or flat for most of 2006, 2007 and the early part of 2008, it correctly predicted big trouble ahead. Right now, it is forecasting a much stronger economy in 2010 than most people think possible.

So there could be a mini boom next year, with real gross domestic product growing at 4 to 5 percent, perhaps with a 6 percent quarter in there someplace. And the unemployment rate is likely to come down, perhaps moving into the 8 percent zone from today’s 10 percent.

The normalization of the Treasury curve is corroborated by the rising stock market and a normalization of credit spreads in the bond market. I note that as the curve has widened in recent weeks, gold prices have corrected lower and the dollar has increased somewhat. So the edge may be coming off the inflation threat.

If market investors expect the economy to grow, inflation at the margin will be that much lower as better growth absorbs at least some of the money-supply excess created by the Fed. My hunch is that inflation will range 2 percent to 3 percent next year.

It also could be that the health care bill about to pass in the Senate is less onerous from a growth standpoint – and certainly less onerous than the House bill. For example, the Senate bill does not contain a 5.4 percent personal-tax-rate surcharge, which also would apply to capital gains. So if the Senate bill becomes the final bill, it will be less punitive on growth.

That could explain the fall in gold and the rise in the dollar. We’ll still be stuck with a tax hike from the expiration of the Bush tax cuts, but at least we won’t have a tax hike on top of that. That’s the optimistic view, at any rate.

But really, pessimists have missed the big rise in corporate profits, the resiliency of our mostly free-market capitalist economy and the monetarist experiment from the easy-money Fed. The optimal policy mix on the supply-side is low tax rates and King Dollar. We don’t have that. So as good as 2010 may be, with investors moving to beat the tax man, it could be a false prosperity at the expense of 2011.

But let’s cross that bridge when we get there. Right now, rising stocks and a wide and positive yield curve are spelling strong economic growth in the new year.

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