The old adage is that Wall Street is driven by fear and greed. And we've seen both on display this year: in a stock market run up, and in the recent "summer slide", which is a well known annual effect that has been stronger in recent years than in the past. The Dow Jones Industrial index, that vernable measure of stock market performance, is off about 8% in recent weeks, having dipped below the 11,000 mark during the day. Foreign markets have also slid as well.

But the real story of this economy is told in two other sets of numbers: in the treasury yield curve and in the VIX. These powerful measures have been saying very clear things over the last year, and what they have been saying has been widely ignored.

The Treasury yield curve is what you get when you plot the interest rate of the bonds that the federal government sells, against how long it takes to pay to maturity. The result generally looks like half a parabola - that curve we all learned in high school - that fell over and decided to take a nap. That is, generally, the shorter the bond's "term" is, the less interest it will pay. Makes sense, the faster you get your money back, the less risk that there was something better you could have done with it is - whether because of inflation, interest rate hikes or other investments. The closer something is to money in hand, the less you can rent it for in the world of bonds.

The distance between the shortest yield - the 1 or 3 month note - and the longer yields, is "the spread" of the curve. The bigger the spread, the "steeper" the curve is said to be. If there is very little difference, the curve is said to be "shallow", if there is a big difference, it is said to be "steep". If there is almost no difference, it is "flat". Occasionally longer yields pay less than shorter ones. The curve is then in some stage of "inversion". A shallow curve means that the bond market is worried about inflation and interest rate hikes by the fed. A steep curve means it is worried about growth.

The VIX is a measure of how "volatile" the Standard and Poors 100 is - the 100 largest US corporations, weighted by their market capitalization. That is big companies like Microsoft and GE weigh alot more than smaller companies that are still part of the index. The "VIX" takes a mathematical formula - called "GARCH" and applies it to the options on this index over recent trading days, weighting recent ones more than older ones. GARCH is a measure of not only volatility, but how volatile volatility has been - not just how much the options are moving, but how fast that rate changes. Like being behind some very fearful drivers - stocks are prone to accelerate fast, then slow to a crawl, and lurch in little gulps.

Between the two of these indexes, on the long scale, there is a story of an economic cycle.

Early on in the economic cycle, the yield curve steepens, as the Federal Reserve lowers interest rates, and the federal government borrows to get out of the recession. But there is still a shortage of investment money, and many are worried that the recovery hasn't "taken hold yet". The result is that the VIX is high - worried that getting in is like "catching a falling knife" - and the spread is "steep". Thus the VIX, and stocks move against each other - when fear is high and stocks have been volatile, chances are the market is low. When fear is low, and people are confident, they pay less for options to insure against losses, and stocks are probably near a local peak. For this reason the VIX is often called "the fear index".

In this stage of the game, banks can borrow short term, from people who are waiting to get in, from the fed, and from those who want their choices open - and find a way to "lend long", to people who are optimistic about the future, and willing to pay for money to do something. This is called, in financial language, "the carry trade". While the carry trade is going on, the way to make money is simply find people who are willing to lend short, make sure you can replace the ones that want to get their money back, and lend long. The premium for finding a pool of short term lenders to lend money to long term borrowers is high.

Over the course of the economic cycle, the fed starts to tighten, and generally the federal government starts to borrow less. The yield curve becomes more shallow, the carry trade disappears. Financial people have to start to work for their living.

During this same time, the VIX falls - from highs when people are fearful and don't want to lose their stake in the game - down towards a bottom. When the VIX reaches its long term bottom, and the yield curve is almost flat, the economy has reached a critical point: from recovery to expansion.

The reason these two events synchronize is this: when the carry trade, in all of its forms, is gone, people have to start taking risks on specific outcomes - they have to bet, not that the economy is recovering, but that specific parts of it will make substantial progress in their ability to take investment and return money. The flat part of the yield curve and the bottom of the Vix mark the moment when a particular economic cycle is either going to live or die. The VIX must go up, because either the economy will slide into recession or inflation, and thus there will be more fear - or the economy is going to be growing because people are taking more risk, and thus hedging their bets.

In 2005 the VIX made, and then confirmed, a bottom, twice. That was as safe as people were going to feel. While in the short run a rising VIX means falling stocks, over the longer term of the business cycle, the VIX falls during the recovery, and rises during the expansion or collapse of a shorter cycle. The VIX bottom marks the middle of a long economic cycle, and the end of a short economic cycle. The question is whether the economy finds something to do with itself.

The measure of whether the economy has is seen in the yield curve. Just as the VIX is going to rise through the expansion, the yeild curve is going to stay flat. The fed and the federal government want to keep the economy on a tight leash, forcing people to invest in growth, rather than invest in inflation. The shallowness of the yeild curve can go on for some time, as the lack of a "carry trade" pushes money into new places looking for returns. Basically, when you can no longer make money by borrowing short and lending long, you've got to actually go out and create the long term.

However, if the yield curve "inverts", that is, gets to a point where short maturities are paying more than long ones, it is a signal of a recession - not always, but almost always. It has always been a sign of slowing economic growth. The reason for this is widely misunderstood, and you will find dozens of financial articles spewing nonsense about the bond market having some prescient knowledge of the economy the rest of is don't have. The answer to that is, if these guys are so smart, why are the investing in bonds, which traditionally return less than stocsks? No one has superior knoweldge of the future as a group. The real reason is simpler: the yield curve inverts when, at the same time, the Federal Reserve is tying to let less money get into the system, and the federal government isn't borrowing more and more money. Less money coming in at the fed's short end, and less demand for bonds by the federal government on the long tend.

There is a long dance of inversion, from the first stages, were a "crimp" forms in the yield curve, to when some short maturities - generally the 2 year - start returning more than the 10 year. Then there is a point where the yield curve is "top to bottom" inverted, that is the shortest term bond yield pays more than the longest. Finally, there is "full" inversion, where every bond pays more than every bond that is "longer" in duration. This is the almost sure fire recession sign.

This is because what is happening is that the fed is putting on the breaks, at the same time that the federal government is reigning in spending. If you think about it, when people feel they aren't getting enough bang for their tax buck, and thus pressuring the government seriously on deficits, that is a very good sign that, whatever the numbers are made or spun to say, that inflation has arrived. Whether in the form of a tax revolt, or in the "Concord Coalition", when the government can't use its ability to borrow longer than anyone to make improvements people can feel, then there is probably inflation in the whole economy.

About two years ago the yield curve started to flatten, and about 18 months ago, the indicators were there that it would at least partially invert. These indicators were when the futures on bonds inverted - that is the prices the market expectd to pay, the foreshadowing of prices to come - inverted.

The bond yield curve started doing the dance of inversion, forming a knee, then inverting in some middle yields, and then towards this beginning of this year, almost getting to the point where it was top to bottom inverted. It came within 4 one hundreths of a percent of doing so. And then stopped.

It is at this point that the economy is on a knife edge. If nothing new is found, then inflation sets in. The fed has to club the economy with a blunt instrument - "bad economy!" - to get people to do something new, rather than charge more for the old. At the same time, because times are good, there is more willingness to put chips on the table and try to bring new goods and services to market. If the fed hits too hard, then the economy stalls an goes into recession.

In essence, when there is no easy money to be made, either the economic cycle has found a productivity win, and grows, or it hasn't in which case confident consumers and business pay too much for old things, and doesn't really grow.

So here we sit - with the fed having to keep lenders and borrowers uncertain about the next move.

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The recent swings of mood - noted by Stephen Roach of Morgan Stanley, and by other observers - between fears of inflation, and fears of stagnation - are indicative of this moment in the economic cycle. At the same time that money has been fleeing stocks, it has been seeking safety in bonds, or betting on inflation in the form of commodities. Some people have fled to gold, that great mattress of the financial system.

To determine what you think, ask yourself a simple question - "what's new?" Are people making new things, or charging more for old things? For me the answer is simple, right now there is a big push for a major build out of the energy system. That is an old thing. We aren't going to give people more or better energy, but merely the energy that they need to protect the capital they have invested in cars, stores, houses and business models. That says that this cycle is about inflation.

If it is, then a recession would be the best thing for the economy, long term. But that's a long term which will see many people ruined. No sitting government is going to push that option. The reason why recession is good long term is that it makes big build outs cheaper, and it makes demand lower, so the economy can change its spots more easily. The other problem is that once the recession trigger is pulled, there is no garuntee that one recession won't follow another - they tend to, historically.

The Fed minutes show a board of governors who are finally conceding that oil and commodity prices aren't going to cure themselves, and that people are still borrowing money to buy houses, thus driving even more demand. Since we have not found a better way to build houses of late, this means that until people stop, there will be inflation. Bernanke doesn't want to trigger a recession, almost no central banker does, but there is a kicking and screaming process where $70/barrel oil and record metal prices for copper are saying tht he may not have a choice.

And this is what is the long term worry - for the last 15 years the game has been to keep inflation down by sending more and more production to other countries. This has helped produce booms in China and India, as well as many other countries that are the "factory floor" for America. It has also produced a boom in commodity prices, as the people who live in these countries, gasp, start wanting electricity and plumbing and telephones and cars and roads and decent airline service. That is, they are no longer willing to make first world goods, while living themselves in third world conditions.

If this is true - and the IMF seems to think it is - then the way of reducing inflationary pressures, neo-liberal globaliation - is at an end as a way of helping keep prices down. That is big, because remember, a huge fraction of the increase in "productivity" has been labor arbitrage - firing expensive workers here in the US, and hiring cheaper workers elsewhere. Inevitably, workers elsewhere stop being cheap. If that time has come, and indicators such as minimum wage rises in China seem to indicate that it has - there is no more win to globalization. This is because we may be reaching the point where every dollar saved of labor costs, is now spent for higher material costs. Because production in China is resource prodigal for every dollar of output, what we are saving in wages, we are simply spending on high rises in Dubai and copper mines in South America.

In the medium term, the VIX is going to march upwards, and that means that people who bet on the right side of the volatility that we have, will make lots of money on it. But it also means that either the economy is already moving on the next big thing - as offshoring and internetworking were in the 1990's - that will make it possible to make old things for less, or new things that make people happy at less cost, or we are headed for a nasty round of rising prices, even lower wage gains, and, inevitably, an early recession. George Soros sees a recession as soon as housing pops, so do other observers who think that the US consumers willingness to spend rather than save is propping up too much of world economic activity. Even bullish commentators agree that if there is a nasty knock to the psyche of the American consumer, then all bets on continued good times are off.

The answer will probably come this fall, when either traders will decide they are confident that new business models and new ideas will carry the day, and buy for the future, or they will come back and either sell - or worse still, double their best on old things, like running up the price of oil, and thus force the fed's hand.