The recent flattening of the yield curve has economists, analysts and bankers wondering what lies ahead. The yield spread between the 10-year government bond and two-year bond declined precipitously from 320 basis points in 2003 to 12 basis points by the end of last month. Investors are concerned that the current shape of the yield curve might portend an economic downturn and increased pressure on bank profitability.

Historically, the yield curve, or the pictorial representation of the yields on the government bonds across the maturity spectrum, has proved to be one of the most powerful tools in forecasting future economic growth. The graph of the bond yields in the market usually slopes upwards, with yields on longer-term bonds higher than shorter maturities, because investors need to be compensated for the greater risk they incur while waiting longer periods for repayment.

While long-term interest rates are sensitive to expectations about economic growth and inflation, short-term rates are more tied to views about what the Bank of Thailand (BOT) will do with its 14-day repurchase rate. Economists, in turn, watch the relationship between rates with different maturities for cues about the economy and how the BOT is managing it.

The current flattening of the yield curve is, of course, rooted in the BOT's decision to raise its official rate. To be sure, the trend picked up steam after the central bank perked up its benchmark rate in August 2004, to rein in mounting inflationary pressures. While yields on short-term government bonds rose significantly, long-term bond yields barely budged for much of the past two or three years, even as the BOT nudged up its official rate from 1.25 per cent to 5 per cent.

Why do analysts pay so much heed to the shape of the yield curve? What imbues it with such power and omniscience?

A barrage of statistics shows that recessions in many parts of the world have often been preceded by significant declines in the differential between short- and long-term yields. Typically, the flattening of the yield curve occurs several months before the onset of a recession. Thailand's recent experience seems to support the yield curve's predictive power. Statistics show there has been a steady decline in the country's rate of growth pari passu a flattening of the yield curve over the period 2003-06.

A slowdown in the country's GDP growth from 7 per cent in 2003 to 6.2 per cent, 4.5 per cent and an estimated 4 per cent in 2004, 2005 and 2006, respectively, was in line with a narrowing in the yield spread from 320 basis points to 207 basis points, 53 basis points and 12 basis points over the same period. Such a strong systematic relationship between the yield spread and economic activity suggests that the odds of an economic downturn increase when the yield curve flattens or becomes inverted - a condition where short-term rates exceed long term rates.

The current yield on the two-year Thai government bond is right now a hair's breadth away from the yield on the 10-year bond, sparking chatter that it could be the harbinger of an economic malaise.

Whilst a flattening or inversion of the yield curve is usually a precursor to a difficult time ahead, it by no means guarantees a recession will come to pass. However, the odds are still pretty good that a significant slowdown in growth momentum will follow a period of flattening yields in the months ahead.

Supachai Sophastienphong

Supachai Sophastienphong is the chief economist at Siam City Bank. He can be reached at suphai1278@hotmail.com.