Last month's attempt by the Hong Kong Monetary Authority (HKMA) to close the gap between Hong Kong dollar and US dollar short-term interest rates has been a resounding success. In solving one problem, however, the HKMA may have inadvertently exposed Hong Kong's banks to another. By introducing a ceiling at which it will undertake to sell Hong Kong dollars, the HKMA pulled the rug from under speculators hoping to make a fast buck from local currency appreciation. As the hot money drained away, the 1.5 percentage point spread between three-month Hong Kong dollar and US dollar interest rates disappeared. Yesterday, the three-month Hong Kong interbank offered rate was 3.23 per cent, little different from its US equivalent. But even as Hong Kong dollar rates have been playing catch-up at the short end of the yield curve, long-term interest rates have been falling. Since mid-March, buying pressure has pushed US government bond prices higher, with the yield on 10-year US treasury notes dropping to trade at just 3.92 per cent this week, only higher than the three-month rate. Now an increasing number of bond market pundits expect long-term rates to drop below short term, producing the dreaded phenomenon of an inverted yield curve, which usually precedes economic recession. US Federal Reserve chairman Alan Greenspan has called the fall in yields a 'conundrum'. Addressing a Beijing conference by video link on Monday, Mr Greenspan dismissed several explanations, including pending economic weakness, pension funds moving into bonds and bond buying by Asian central banks. US economic guru Maria Fiorini Ramirez offers another explanation. She argues that investors' enthusiasm for Treasury paper is symptomatic of a flight to quality following a series of corporate shocks in America. The downgrading of GM's debt to junk status, accounting and governance scandals at AIG and United Airlines' application for Chapter 11 bankruptcy protection have blunted investors' appetite for individual company risk. Facing redemptions, hedge funds have been especially keen to switch into US government debt, which is both more liquid than corporate bonds and less susceptible to event risks. 'People don't know who to trust any more,' Ms Ramirez says. 'Everyone is running for the door at the same time.' She believes the stampede will push bond yields below short-term interest rates as the Federal Reserve continues to tighten monetary policy over the coming months. For once, however, an inverted yield curve will not herald recession, she says, arguing the economic outlook will remain moderately bright. Where US yields go, Hong Kong dollar yields will follow. Over the past year the yield on the 10-year Exchange Fund note has faithfully tracked the equivalent Treasury yield lower to trade at 3.92 per cent yesterday. If the US curve inverts, so will the Hong Kong dollar curve, especially now that the HKMA has ensured short-term rates trade in line with their US counterparts. That poses a big threat to Hong Kong's banking sector, particularly to the smaller banks. Traditionally banks have made their money by borrowing in the near term, lending out over longer time periods, and pocketing the difference in interest rates. An inverted yield curve will play havoc with that business model. The biggest banks, which are able to borrow very cheaply from their depositors, will not suffer much. But smaller banks that source their funds from the more expensive interbank market will see their spread, and their principal source of earnings, eroded entirely. In the past, intervals of yield curve inversion have seldom lasted long. But given the profusion of small lenders in Hong Kong, it may need only a short period to spur consolidation and drive some of the weaker banks into the arms of their larger competitors.