Ignore That Rate Curve

Narrowing of T-bond yields no longer means a slowdown

Has the Fed already tightened too much? That's the message that interest rates seem to be flashing. Since December, the Treasury yield curve--which normally shows interest rates rising smoothly as maturities lengthen--has gotten flatter. The 30-year Treasury bond's yield even dipped below that of 10-year notes in mid-January, and stayed there, the longest stretch of inverted yields since 1994. For the past 20 years, such a shift in rates has heralded a slowdown. Today's yield curve could be deciphered as a warning that the Federal Reserve's three rate hikes since June have already clobbered the economy.

But it's time for a new codebook. The ominous-looking droop in 30-year Treasury yields is a phony signal, economists say, because it results from the Treasury Dept.'s decision to use federal budget surpluses to buy bonds back from investors. More broadly, Fed-watchers say, financial-market changes during the 1990s have scrambled the yield curve's message about future economic activity.

Scratch the 30-year bond, and today's yield curve paints a fairly benign picture (chart). The 0.86-percentage-point difference between yields on three-month T-bills and two-year notes anticipates more Fed tightening--perhaps lifting the Fed's target rate for federal funds from 5.5% to 6.25%. But the flatter rates for longer maturities mean that "the Fed will get a gradual slowdown without having to tank the economy," says Joshua N. Feinman, chief economist at Deutsche Asset Management.

What most worries traditional readers of the yield curve is the dip in rates on 30-year bonds. The yield on the Treasury's bellwether security has dropped from 6.71% on Jan. 12 to 6.64%--below the 6.70% yield of the 10-year note. But that shift coincided with Treasury Secretary Lawrence H. Summers' Jan. 13 announcement that Treasury would buy back $30 billion in bonds this year. Summers hinted that buybacks would concentrate on longer-term bonds. So investors bid up the price of long Treasuries, driving down their yield.

It's unusual for Summers' impact on the yield curve to outweigh that of Fed Chairman Alan Greenspan. But it's no fluke that the yield curve is losing its predictive powers. When academics and Fed officials started using it for forecasting in the late 1980s, "very few businesses could borrow money for 10 years or longer," says Louis Crandall, chief economist at economic consultants R.H. Wrightson & Associates. But financial derivatives, which let short-term borrowers lock in long-term rates, "have made the economy more sensitive to bond rates," Crandall says. Now, when the yield curve inverts, the drop in long rates stimulates borrowing, which can nip a recession in the bud.

The curve's promise of a soft landing doesn't come with any guarantee. Lenders and consumers have shrugged off the Fed's last three rate hikes. But rising rates will start to put on the brakes, especially if they draw nervous money out of stocks and into bonds. If not, the Fed will have to hit the economy harder to slow it down, inflicting pain that will surprise the bond market as much as everyone else.

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