Bond market predicts economic recovery
The relationship of long- and short-term interest rates often proves clairvoyant. CNBC’s Ron Insana explains the mysteries of the “yield curve.”
Want to figure out where the economy is headed? Watch the bond market, not the stock market. One of the best indicators of recession and recovery is a rather arcane market tool known as the “yield curve,” the difference between long-term and short-term interest rates. Right now, the curve paints a bullish picture.
Think of Treasury-market investors as lenders. They lend the government money in return for interest payments. In normal times, investors demand higher interest payments for long-term loans than for short-term loans. The reason is simple: The longer a period of time before the bond matures, the greater chance of an inflation pickup and the higher the opportunity cost of not investing in other assets, such as stocks.
Always focused on inflation
If you buy and hold a 30-year bond with a 5% yield, and inflation stays low, you're fine. But if inflation suddenly jumps, those interest payments may seem paltry. That’s why bond yields rise -- and prices fall -- when the economic outlook improves. Investors assume that inflation is a natural consequence of economic growth.
During periods of moderate economic growth and “healthy” inflation, long-term yields remain above short-term yields. That's the normal shape of the yield curve.
Predicting a recovery
Right now, the curve’s slope is quite steep. Thirty-year Treasurys (TC30Y, news, msgs) yield about 5.5%, while two-year Treasury notes (TC2Y, news, msgs) yield 3% and three-month T-bills (TB3M, news, msgs) pay only 1.7%. The message is clear: The sluggish economy poses no inflation threat right now, but growth and inflation ought to be heading higher.
Until recently, the curve was inverted. Long-term Treasurys yielded less than short-term ones. Rate hikes by the Federal Reserve in 1999 and 2000 convinced bond investors the economy would slow and possibly even contract. Market participants figured short-term Treasurys were more vulnerable to inflation than long-term bonds.
Unconsciously, bond investors collectively predict the future. They figure rate hikes aimed at slowing the economy also lower the odds of inflation. And they often rightly predict the Fed will step too harshly on the economic brakes.
Best indicator in the toolbox
Historically, the yield curve has been a good predictor of recessions. Going back through six recessions to 1960, in every case, the shape of the yield curve has proved an accurate indication of our economic fortunes -- a much better record than the stock market’s.
But few investors heeded the bond market’s recent signals. They dismissed them primarily because of the newfound budget surplus. They figured the reason bond prices shot so high, was because 30-year Treasury bonds were becoming scarce. During surpluses, the government can pay off more debt than it borrows.
But in the end, the bond market’s message was spot on. And now that Treasurys appear to predict a recovery, investors seem to be paying attention again. |
