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Yield Curve

 
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arthur
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PostPosted: Sun Feb 27, 2005 3:21 pm    Post subject: Yield Curve Reply with quote

Click link for article with graphs.

http://www.marketwatch.com/news/story.asp?guid=%7B5D388F16%2D6126%2D4F89%2D8ADE%2D521C90CCAE8A%7D&siteid=mktw&dist=

Bond market as economic beacon
Yield curve anomaly worth watching, but message unclear
By Rachel Koning, MarketWatch

CHICAGO (MarketWatch) -- The yield curve may only be a graph that plots the range of future returns on bond investments from shortest to longest maturity, but its fortune-telling attributes have utility on Wall Street and Main Street alike.

Right now, however, many economists and strategists think that outside factors are fogging up this crystal ball. The yield curve may not be behaving as it normally should in a rising interest-rate environment, but neither is it following its historical pattern in signaling an economic slowdown.

It's "proven to be one of the more powerful forecasting tools available, so it is quite rational for the yield curve to be receiving so much attention," said Tony Crescenzi, chief bond market strategist with Miller Tabak & Co.

"Fresh in many investors' minds is undoubtedly the unheeded message that the yield curve sent in January 2000 when it inverted," Crescenzi said. "The Nasdaq, of course, did not peak until two months later."

Should the recently flattening U.S. government debt curve invert, with short-term yields above longer-term yields, the graph could be flashing a warning - recession. The Federal Reserve would have to rethink its interest-rate policy, and soon.

Some curve flattening over a short period of time can be expected when the Federal Reserve begins tightening the lending screws. The short-maturity end of the bond market had to adjust to the change in attitude at the Fed. After all, the central bank had held interest rates at four-decade lows for much of 2003 and early 2004.

Most likely, both short- and long-term yields would be rising with the Fed tightening, but with the short end of the curve rising at a faster clip.

Short-term yields are indeed rising. But their longer-term counterparts are not.

"If this curve were to invert, which I don't think it will, it would be the first time since Bretton Woods [economic summit in 1944] that the curve was flattening with short-term and long-term rates going in opposite directions," said Liz Ann Sonders, chief investment strategist with Charles Schwab.

Fed chief Alan Greenspan quelled most worries about the fitness of the economy in Capitol Hill testimony earlier this month. See related story.

In the wake of Greenspan's testimony, the difference in yield between a 2-year Treasury note and a 10-year Treasury note - a commonly used comparison - has widened back out to around 75 basis points, or 0.75 percentage point, as of Friday. That compares to a 3 1/2 year low of 71 basis points in early February.

Despite its technical-sounding name, the curve simply reflects bond investor expectations on where interest rates will stand in the near term, medium term and long term and what impact inflation might have on those returns. Trying to predict where interest rates are headed is also a guess at economic strength and stock market levels.

Federal Reserve researchers have found the yield curve to be a more accurate harbinger of future economic activity than, for instance, the index of leading economic indicators issued monthly by private research group the Conference Board, Fed economists wrote in a late-1990s paper.

Based on the findings of the Fed's Arturo Estrella and Frederic Mishkin -- they use the yield spread between a 3-month Treasury bill and a 10-year Treasury note - the current flat curve only reflects about a 2 percent chance the economy will tip back into recession.

The spread between a 3-month Treasury yield and a 10-year yield was around 1.5 percent this month. Only when that relationship narrows to a quarter percentage point do recession odds break above 20 percent.

Not a true picture

Should financial markets pay any attention to this gauge right now?

"It is scary when one realizes that the U.S. yield curve is not really representative of inflation expectations in full, but reflects the visible hand of governments, the orgy of currency intervention in Asia, the recycling of $50 a barrel oil by OPEC and more recently a determined effort by U.S. firms to reduce under funded pension liabilities," David Gilmore, a partner in research firm Foreign Exchange Analytics, wrote in a research note.

Other analysts agreed that Bush administration-proposed changes calling for greater pension transparency could boost demand for longer-dated bonds in particular.

In other words, long-term U.S. debt remains in hot demand, driving down yields.

Greenspan, too, told lawmakers he's left scratching his head over why the yield on the benchmark 10-year Treasury note had been falling even as the U.S. central bank telegraphs more interest-rate hikes. But he entertained the prospect of outside influences. See related story.

Narrowest yield gap in three years

Still, the curve's change in the past several months and even more dramatically in recent weeks has made it a frequent topic of analysts' notes.

In those several months, short-term Treasury notes have been falling in price and rising in yield in step with the Federal Reserve's six short-term interest-rate hikes since last summer. But, longer-term notes, including the benchmark 10-year security, have gained in price - or are at least holding their ground - allowing yields to drift lower.

One year ago, the gap between the 2-year and 10-year yields was as wide as 2.4 percentage points.

In a period of a fast strengthening economy, the yield curve might tend to angle upward fairly sharply from left to right, a positive slope indicative of expectations that with faster economic growth comes the increased risk of inflation. Holders of long-term debt will demand higher yields to compensate for inflation. If the bond market thinks the Fed is behind in its inflation fight, long-term yields will rise faster than their short-term brethren and the curve will steepen more abruptly.

So far, the U.S. central bank continues to tell financial markets that its "measured" pace of removing interest-rate accommodation is still appropriate. The Fed, apparently, is confident it remains a step ahead of inflation and isn't rattled by mixed signals from the bond market. Greenspan said as much this week.

"If anything, the flattening of the yield curve contains a positive message in that it is signaling confidence in the inflation outlook," said Miller Tabak's Crescenzi.

The narrow gap of late is a key reason that long-term mortgage rates have held below 6 percent. Consumers - and the Federal Reserve -- are pleased, no doubt.

But there are implications from a flat yield curve for the financial sector, which has borrowed extensively at low short-term rates, only to see their interest costs now rising and their bets on a much brisker economy fall short. The mortgage finance market has also had to adjust. See story on curve's impact on banks.

A big question hanging over financial stocks is when will the risks of rising interest rates come home to roost for the banking sector, says Schwab's Sonders and other analysts.

Despite her confidence that the curve isn't signaling looming recession, the curve's shape nonetheless is partly behind Schwab's recommendation to lessen financial and banking stock exposure. The firm raised its recommendation for consumer staples and utilities to neutral from underweight in light of its yield outlook.

Greenspan vs. the bond market

Certainly, the bond market can flub it.

The market was caught wrong-footed last summer as it positioned for a much more aggressive Federal Reserve than reality delivered.

"When Fed tightening began in June, the yield curve was very steep, as steep as any time in 80 years," said analysts at Bridgewater & Associates, in a note. "In other words, a lot of [interest-rate] tightening was already discounted.

"As the Fed tightened, bond yields fell because short rates fell. Forward short rates fell because the markets anticipated that the tightening would slow the economy and inflation. This perception was reinforced by a series of economic numbers coming in slower than expected."

Sonders agrees that one key feature of the current curve is that short-term rates were so low that even what appears to be a dramatic yield curve adjustment is really just a correction. Increased business loan demand, which could drive up short-term rates even more dramatically, isn't happening because companies are sitting on more cash than they've had for several years.

Signs point upward

The yield curve may be flat now, but not for long, some experts think.

"From a U.S. perspective, the view of the curve is that government debt yields remain artificially too low, considering the relative state of stronger growth prospects and the Fed set to keep on reeling back its policy accommodation," said Bear Stearns chief European economist David Brown. "Yields will trend higher this year."

Whether the Fed likes it or not, the government may soon do its part in lifting longer-term yields.

"Given the current low yields, there is little doubt that the Treasury will soon start cranking out long-term paper to fund its budget deficit at low rates," said Alexander Paris, an analyst at Barrington Research Associates.

"This is clearly not an environment that would suggest significant inflation risks, so our assumption of only modest increases in long-term interest rates and inflation for 2005 would still seem a safe bet," said Paris.

Bill Gross, managing director of leading bond fund firm Pacific Investment Management Co., said in his March outlook released this week, that he's favoring inflation-protected Treasury investments and foreign bonds. He's guessing the 10-year yield has found a floor at 4 percent.

If the bond market and the Fed have it right, the change toward an upward sloping curve will be gradual and easy to adjust to. If they're wrong, the yield curve would become less of a beacon and instead, a snapshot of a bond market scrambling to react.
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