Connect The Dots...And You'll See A Slowdown

Analysts who plot interest rates forecast sluggish growth

Ancient stargazers drew imaginary lines across the night skies, connecting stars into images of man and beast. They studied the course of the heavenly bodies through the skies and eventually used them to forecast the future--and thus was born the practice of astrology.

Nowadays, market analysts and economists play a similar game. On a graph, they plot the interest rates for a series of maturities from three months to 30 years. Then they connect the dots to create what's called the "yield curve"--and divine forecasts about the economy and the financial markets from the look of the line. They even invest on what the dots tell them.

Astrology? Not really. Just sound economic and financial analysis. "Yield curves have proven to be pretty good leading indicators of economic activity," says Michael R. Rosenberg, head of international fixed-income research at Merrill Lynch & Co. Right now, the yield curves of major industrial nations, he says, are sending much the same message: slower growth ahead.

Let's look at the curve for the U.S. From the yield on three-month Treasury bills, 5.20%, to that of 30-year Treasury bonds, 6.25%, is a scant 105 basis points (each basis point is 1/100 of 1%). Back in April, when long-term interest rates were at their high point for the year, the difference between the shortest and longest Treasury securities was 188 basis points. When plotted on a chart, the April yield curve was seen to be "steep." Today's is "flat," and the movement of interest rates from April to November is called "flattening."

The flattening of the yield curve is typical behavior for late in an economic expansion. Normally, the curve flattens as the Federal Reserve Board, trying to slow a steamy economy and thwart inflation, hikes short-term interest rates higher and higher to the point where they approach longer rates. Long rates may climb then, but not much because higher short rates usually slow economic activity, and that curbs inflation.

FEWER GAMBLES. But this time around, the flattening process played out quite differently. There has been no shift in monetary policy since March, when the Fed hiked short-term rates 25 basis points, and short-term rates have remained largely unchanged since April. The shape of the curve has been altered mainly by the drops in yields in longer-term maturities. "We've had a sharp reduction in long-term rates because there's less fear of inflation in the future," says Frederic S. Mishkin, an economics professor at Columbia Business School and a former research director of the Federal Reserve Bank of New York.

At least that's a message investors are sending to the Fed through the yield curve. Still, Mishkin doesn't think the Fed is going to let down its guard on inflation with the economy still growing at an above-average pace and with labor markets tight.

None of the yield curves of other industrial nations looks quite like that of the U.S., but their message still points toward slower growth. In Germany, the yield curve is steeper than in the U.S., but recent hikes in short-term rates have flattened the curve from the short end. Japan's steep yield curve is flattening as well. Or consider Britain, where the one-year yield, at 7%, is more than half a percentage point higher than the 30-year bond. That's when the yield curve goes beyond flat and becomes "inverted," a result of a restrictive monetary policy that's often a precursor of a recession.

With yield curves around the world pointing toward slower economic growth, bonds, even at today's relatively low yields, make compelling investments. A 6.25% yield in an era of 2%-to-2.5% inflation is a good deal. But what about bond market volatility? No problem, says William H. Gross, who oversees $108 billion in bonds for PIMCO Advisors: "The flatter curve suggests lower volatility in rates, and that makes bonds better investments."


While all bond market players see the same numbers, they don't all see the same patterns. Ian A. MacKinnon, who heads up the bond funds at Vanguard Group, says that the shape of the curve suggests there will be a half-percentage hike in short-term rates one year hence. MacKinnon says the drop in long-term rates that realigned the curve in the last several weeks has little to do with economic fundamentals and more with "the uncertainty in stocks." Much of the money that exited the wildly gyrating global stock markets ended up in Treasuries. "The fearful bought the short-term, the speculators the long-term," he says.

But the switch out of stocks and into bonds does have an economic message. It's a signal from investors that they're pulling in their horns, taking fewer chances, putting their money where there's a little more certainty and a little less risk. That behavior, echoed through the economy, is the making of a slowdown. And it shows up first not in the stars but in the earthly yield curve.

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