I wanna be an anarchist
Oh what a name
Get pissed destroy!
-- Sex Pistols
Our Farther-land across the Pond has been much more aggressive in raising interest rates than our own Fed. Despite the headline grabbing attention the US yield curve has just received, the UK has lived with an inverted yield curve for more than a year now. The chart below shows the yield curve for each of the last three years starting in January 2004. The UK yield curve actually flattened out between September and October of 2004, much like the US curve is currently doing, and then inverted in November of 2004.
Predictably, the yield curve forecasted a slowing economy. Interestingly, the inversion coincided with the slowdown in UK GDP growth. Conventional wisdom states that the yield curve forecasts a slowdown two to four quarters in the future. I'm not sure if this means that our current flat yield curve is indicative of an already-slowing economy but it's worth keeping a close eye on economic indicators.
Unpredictably, the flattening yield curve and slowing economy have lead to a roaring bull market in the FTSE. This is why you don't find too many millionaire economists. It's very difficult to make any correlation between economic statistics and stock market performance. And usually, if there is a correlation, it's an inverse relationship - good is bad and bad is good.
The strong UK stock market can be attributed to several issues. First, the market correctly identified when the central bank would stop raising rates. The banks last rate hike came in August 2004 when it stopped at 4.75%. Shortly thereafter, the FTSE started its strong run. The central bank lowered rates in August 2005 to 4.5%, where they stand today. Second, earnings for UK companies have remained relatively strong. Third, global liquidity remains high. Despite relatively lackluster economic performance (Germany and France have been hovering at or below 2% GDP growth since 2000), all European markets had big gains last year.
The UK's experience probably means the US's flat yield curve is forecasting a slowing US economy. Whether this, in turn, forecasts a weak stock market will be determined by the Fed's actions, commodity prices, global liquidity and company earnings. But as in the UK, the inverted yield curve itself doesn't mean the stock market will experience anarchy in the USA.