Whether a harbinger of troubled economic times or a quirk due to light trading around the holidays, this week's bond-market flip —...

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WASHINGTON — Whether a harbinger of troubled economic times or a quirk due to light trading around the holidays, this week’s bond-market flip — where long-term investments briefly fetched lower interest rates than short-term ones — bears close watching.

Yields, or the return, on 10-year Treasury notes Tuesday dropped slightly below the yields on two-year notes for the first time in five years.

This phenomenon, also evident for part of Wednesday’s trading session, is called an “inverted yield curve.” In the past, it has often preceded a recession.

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Typically, longer-term instruments have higher interest rates to compensate investors for tying up their money over a longer period, a decision that can be fraught with uncertainty.

When the situation reverses, it signals bond investors bet interest rates will dip in the future, something that can happen if the economy were to slow or slip into a recession, blunting inflation concerns.

For now, though, many analysts — while keeping close tabs on the behavior of bonds — — are not ready to ring the alarm.

A number of other, more positive forces may be helping to keep long-term interest rates unusually low.

Economists said one reason may be investor confidence in the Federal Reserve’s inflation-fighting prowess. The hearty appetite of foreign investors for U.S. Treasury securities — viewed as one of the most safe investments in the world — is believed to be another factor.

Competition from an ever-growing global marketplace has helped to keep inflation under control and also may explain the low longer-term rates, economists said.

Tuesday, the yield on the 10-year Treasury note was 4.34 percent, a tad lower than the two-year note’s yield of 4.35 percent.

The yields, which had hovered in that range for part of Wednesday switched by the close of trading. The 10-year yield stood at 4.37 percent, up a notch from the two-year’s yield of 4.36 percent.

Tiny spread

Analysts pointed out that the difference, or spread, between the two is tiny and comes during the holidays, when trading volume is light and can magnify movements in bond prices.

Bond prices and yields move in opposite directions.

Against this backdrop, Mark Zandi, chief economist at Moody’s Economy.com, said he thinks the inversion’s message is muddled.

“I think what we are seeing with the bond yields is a byproduct of globalization,” Zandi said. “That being said, I think it is something to watch and to understand better. But I am not overly concerned.”

Zandi and other analysts continue to believe the U.S. economy will remain in good shape.

It grew at a stellar 4.2 percent in 2004 and is expected to log solid growth of around 3.6 percent this year and 3.3 percent in 2006, according to some projections.

Out of date?

Federal Reserve Chairman Alan Greenspan and others have indicated that given the forces — especially global ones — that can affect U.S. markets, the inverted yield curve may no longer be a useful predictor of economic activity.

“Many factors can affect the slope of the yield curve, and these factors do not all have the same implications for future output growth,” Greenspan wrote in November in response to a lawmaker’s question.

Still, economists weren’t willing to shrug off Tuesday’s flip. The last recession, in 2001, was preceded by an inverted yield that began in 2000.

Inverted yield curves preceded the last six recessions, analysts said. But there were two times, most recently in 1998, when the yield curve inverted but no recession followed.

Signs of trouble

If the flip seen Tuesday were to be sustained, and the gap between the yields on the two-year and 10-year Treasury notes were to widen, it could spell trouble, analysts said.

Credit could get seriously crimped, they said. Banks normally borrow money at short-term rates and lend out the money at longer-term rates.

“When the yield curve inverts, banks’ funding costs rise above what they earn by lending. This can produce a credit crunch,” said Greg McBride, senior financial analyst at Bankrate.com.

The housing market also could be hurt if the pool of money for lending dried up.

Well before Tuesday’s flip, the yield curve was flattening, analysts said, as the Federal Reserve boosted short-term rates.

Rate “conundrum”

During that time, however, longer-term interest rates have stayed surprisingly low and the economy has motored ahead. Greenspan once referred to this puzzling divergence in rates as a “conundrum.”

The Fed’s key short-term rate, the federal-funds rate, stands at a 4 ½-year high of 4.25 percent.

The funds rate is the interest banks charge each other on overnight loans; it directly affects the prime lending rate as well as short-term adjustable rate mortgages.

Another increase in the funds rate is expected Jan. 31, Greenspan’s last meeting as chairman.

After that, the reins will be handed to Ben Bernanke, who will have to deal with future economic challenges.