Should we have a steepening yield curve if Mr. Bond Market expects surpluses as far as the eye can see? And if we don't get the surpluses, what sort of tax cut should we have? And what will happen to the dollar? To interest rates? I don't pretend to have thought all this through, but it is beginning to feel more and more ominous long term to me.
Some musings on the (steep and getting steeper) yield curve:
biz.yahoo.com
SmartMoney.com - The Long View
Get a Load of Those Curves
By Jersey Gilbert
WE ARE ONCE again on the eve of another eagerly awaited Federal Reserve
meeting. Here's a quick test of your investment acumen: Are interest rates rising
or falling? If you're sure they're falling, repeat after me: ``I will not get my market
information from the nightly news. I will not get my market information from the
nightly news....'' Do that over and over for 10 minutes.
The nightly news (as well as many respected financial
publications) usually oversimplifies the interest rate
situation. They miss all the nuances that make rate
movements meaningful. Here are the facts. Key
long-term rates have been rising for some time. The
10-year Treasury bond bottomed on March 22 at a yield
of 4.74%. It has been drifting up since then and now
stands at 5.43%, almost a three-quarter-point rise. The
30-year yield is also up more than half a point, from
5.26% to 5.85%, in the same time.
Admittedly, shorter-term Treasurys in the one-year to
five-year maturity range are still hovering around their
lows, while the very shortest term rates, those controlled
directly by the Federal Reserve or strongly influenced by
Federal Reserve actions have, of course, been going
down. Don't put too much weight on that, however. In
the bond market, the longest maturities are typically the
first to foretell where interest rates are headed. When
short-term rates and long-term rates move in opposite
directions, that's significant.
For instance, last year, 10-year Treasury yields started falling on Jan. 24, and came down 1.75 percentage points before
Greenspan & Co. lifted a finger to start pushing short-term rates down. The drop in long-term rates turned out to be the
earliest reliable signal that the economy was headed for trouble.
Most stock-market investors nowadays ignore the bond market. Compared with the volatility and upside potential of
equities, the risk-reward profile of bonds seems unappealing. Furthermore, if you don't know much about bonds, the
day-to-day price movements probably appear like small change as you follow them in the paper. But just because you may
not want to invest in the bond market doesn't mean you should ignore it.
That's because the bond market determines the shape of the yield curve, and the yield curve is one of the best long-term
economic indicators available to the average investor. It can dramatically change its shape up to a year before significant
economic events. Back in 1989, it inverted (more about that in a moment) in what turned out to be advance warning of the
Gulf War recession in 1990.
When I designed the SmartMoney economic indicators back in 1995, I wanted to limit the selection to commonly accepted
signals that were easily available to anyone with limited information resources. I found only five that historically proved to
be consistently reliable. The yield curve was one of them.
The curve is simply a map of the implied interest rates on bonds of different maturities. It changes shape when yields of
one type of maturity start moving in a different direction or faster than yields of another type. That's when you should take
note, whether you're a bond investor or not.
Like the prices of bonds, the yield curve changes shape slowly by stock-market standards. It takes a month or so for a new
pattern to get established. So just make a point of checking it every couple of weeks. Back in January, the curve was
completely inverted, with overnight rates at about 6.5% and 30-year yields around 5.4%. (The curve is said to be inverted in
such circumstances because buyers of longer maturities usually demand higher yields to compensate them for the added
risk of tying up their money for greater periods of time.) Now the situation has completely reversed. Overnight rates are
4.5% and 30-year yields are 5.8%. Clearly something significant happened in between. That difference was what led me to
write a column last January warning that the New Year's rally probably wouldn't last, and what led me to write a cover
story for the May issue of the magazine asking if you were ready for the rebound. The bond market clearly wasn't ready to
pronounce the economy ready to recover four months ago. It is indicating at least a temporary recovery right now.
What changed, exactly? The simplest explanation of the yield curve see-saw that we've just witnessed is this: Short-term
yields respond more to the liquidity of the money markets (another way of saying the availability of money); long-term
rates respond more to the inflation outlook.
Back in January, before the Fed started pumping money into the banking system, concerns about liquidity — for instance,
loan defaults and the overall reluctance of banks to lend — were keeping short-term rates up. At the same time, the slowing
of the economy relieved worries about more inflation — in spite of rising gas and oil prices. It's pretty hard to have
massive inflation in a recession (the unusual stagflation of the 1970s was a notable exception). The result: Long-term rates
fell.
Today, we have the opposite. The Fed is pumping money into the banking system. Meanwhile, with the economy
stubbornly refusing to slip into recession, long-term bond investors are no longer completely anxiety-free on the inflation
front. Bond investors are quickly returning to their usual habits of worrying incessantly about commodity shortages and
rising prices.
That's an oversimplification, to be sure, but it's enough context for the stock investor to know that the mood in the bond
market has clearly changed since March. It isn't that an inverted yield curve is uniformly bad for stocks and a ``reverted''
curve is good. The change is more like rolling from a forest to grasslands in your Conestoga wagon. It's a lot easier to see
your way on the prairie, but you have to start worrying about getting enough firewood and water.
In the stock market, the effect of these changes in the shape of the yield curve and the mood among investors can best be
seen at the sector level. Over the last year or so, the inverted yield curve signaled falling interest rates and good times for
sectors that were interest rate sensitive, like financial services, utilities, real estate, construction and Old Economy
consumer-staples companies with high dividends. All those sectors were great places to be up until now.
Meanwhile, capital spending declines when money is in short supply and the economy contracts. Sectors that depend on
capital spending — in particular, information technology, business services and industrial equipment — have a tough time.
Now that the bond market is becoming more worried about a strengthening economy, and the Fed is liquefying quickly —
to the point where its cycle of rate cutting might be approaching an end — stock investors should start re-examining their
sector strategy.
The change in the yield curve is already starting to have an effect on the fundamentals in some industries. Sooner or later it
will have effects on the others. Take mortgage lenders. Fixed mortgage rates follow the 10-year Treasury yield movements
very closely. Up until March, falling 10-year yields were great for the refinance business. Thrift stocks like Washington
Mutual (NYSE:WM - news), and mortgage stocks like Fannie Mae (NYSE:FNM - news) and Freddie Mac (NYSE:FRE
- news) were on a tear last year because of it.
Check out their charts this year, They've been trading in a range. Sure enough, HSH Associates' weekly survey of national
30-year mortgage rates bottomed on the week ending March 23, when the average was 7.07%. The May 4 survey showed
7.31%. Average weekly rates slipped back a bit last week, but Keith Gumbinger, chief analyst at HSH headquarters in
Butler, N.J., told me that mortgage rates came roaring back Friday, and it's a good bet they'll keep rising this week. If
you've been following the bond market you've seen it all coming.
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