The Bond Market's Compass Points North
By Margaret Popper
If you were watching the fixed-income markets closely in February and March of last year, you would have known an economic slowdown was coming by the end of 2000. The yield on two-year Treasury notes was about a percentage point higher than the yield on the 30-year Treasury bond. In bond-market lingo, that's known as an inverted yield curve -- and it's generally considered a sign that an economic slowdown is on the way.
On the flip side, a steep yield curve -- one with long-term rates significantly higher than short-term rates -- is the precursor to a recovery. That's the kind of yield curve we've got right now. So you would think the financial world would be rejoicing and that Federal Reserve Chairman Alan Greenspan would be claiming victory. That's not happening yet. The reason: Aside from imminent recovery, a steep yield curve can also reflect inflation fears and the perception that the Fed's easing cycle is nearing the end.
There's one more fly in the ointment: The yield curve isn't as pronounced as in past recoveries because the U.S. Treasury is now buying back long-term debt, thereby making 30- and 10-year Treasuries scarce commodities that trade at higher face values and artificially lower yields.
But make no mistake. With the 4.22% yield on the two-year Treasury note a full 1.4 percentage points below the 5.63% yield on the 30-year bond, the current yield curve is telling us recovery is on the way. The important thing to focus on is the direction of the curve. In a little over a year, it has gone from a 1 percentage point inversion to a 1.4 percentage point positive slope.
If the past two economic cycles are anything to go by, recovery could happen as soon as the third quarter or as late as the fourth. But most likely, the steepening of the yield curve is just one more bit of evidence that the slowdown will be over before yearend.
The yield curve steepens before a recovery because the bond market anticipates Federal Reserve policy. When economic growth is too sluggish, the market starts betting that the Fed will cut rates, and bond yields start to drop in anticipation of easing.
As the Fed actually lowers the fed funds rate -- the rate at which banks borrow money from each other overnight -- bond yields drop further. Fed easing in the face of a slowdown pulls down yields on bonds with maturities as far out as five years. Beyond that, it's too hard to predict where interest rates and economic fundamentals will go, regardless of what the Fed is doing in the short term.
As a result, 10- and 30-year bond yields start to move up, because they're far more uncertain than yields on debt with shorter maturities. They also reflect a concern with inflation. "The fear is that the Fed might overdo its easing, and the current level of price increases could become the floor not the ceiling level of inflation," says William Dudley, economist at Goldman, Sachs & Co.
Fueling inflation concerns right now is the worry that companies will try to prop up flagging earnings by raising prices. Given the worldwide slowdown, there might not be sufficient global competitive pressure to prevent this. On the other hand, it's anticipated that crude-oil prices will continue to fall, despite a refining capacity shortage that has pushed gas prices up at the pump. In addition, the May 4 report on unemployment and job creation will likely show that wage increases are slowing. Standard & Poor's Corp.'s investment-policy committee anticipates a 0.3% increase in nonfarm hourly wages, vs. a 0.4% increase in March.
A steep yield curve tends to buoy the equity markets. "The more the Fed encourages a steep yield curve, the more it creates the capital market conditions for growth," says Jack Malvey, chief global bond strategist at Lehman Brothers. More capital becomes available to corporations because banks are able to borrow in the form of using deposits on which they pay low short-term rates to finance long-term investments at higher yields. In contrast, when the yield curve inverts, the short-term interest banks pay on deposits is higher than what they can earn on loans.
Worried about credit quality, banks have been slower to turn their increased liquidity into loans than they have been in the past, a phenomenon that may be slowing the recovery. "Over the past four or five years, banks have had several stress tests, including the Asian contagion in 1998, and last year's yield-curve inversion," points out Malvey. "These [stress tests] reinforced the notion that financial institutions need to be wary of credit risk." As a result, credit committees in financial institutions around the world have spent the past two or three years tightening their standards. Good for their balance sheets, bad for a speedy recovery.
But if banks aren't lending with both pockets, the bond markets seem to be. So far in 2001, $250 billion of corporate debt has been issued. That's compared to $330 billion for all of 2000, a record-breaking year. Corporations are rushing to the bond market to take advantage of lower short-term rates to reduce their overall cost of funds -- the same way homeowners refinance mortgages when rates are falling.
When you consider that current high-quality corporate credits are trading 2.5 percentage points above the yield on the 10-year Treasury note, and that historically they've traded around one percentage point above the 10-year, it's no wonder that institutional investors want to take advantage of the current yields. The spreads are wider because there's more business risk at this low point in the economic cycle.
The curve's behavior over the past week may just be in anticipation of the end of easing. "The perception is that we are nearing the end of the phase of easing, and that generally means that the curve steepens in a more gradual fashion," says Michael Ryan, senior fixed-income strategist at UBS PaineWebber.
If that's what the yield curve is predicting, that's good news for the economic outlook. It means the Fed is convinced that the economy has enough momentum to recover without too much more monetary stimulus. If so, we might see improvement in the gross domestic product as early as sometime in the third quarter.
Popper covers the markets for BW Online in our daily Street Wise column
Edited by Beth Belton