Piercing the Bond Market's Confusion

Low rates imply impending deflation, while the steep yield curve portends recovery and higher prices. Chances are it's the latter

By Margaret Popper

The bond market is one place economists and investors always look for clues about the future of the economy. Unfortunately, bonds aren't giving a single clear signal these days. Interest rates are extremely low compared to historical norms -- which could be a sign of falling prices. But the gap between rates on the three-month Treasury bill and the 10-year Treasury bond is larger than normal. In bond market lingo, that's known as a steep yield curve -- and it usually presages an economic recovery and the resurgence of rising prices.

What should investors make of these divergent signals? The best bet is to keep an eye on that yield curve, which seems to be signaling that the economy is likely in a slow, steady recovery that would eventually put it back on the path of higher inflation. Milton Ezrati, senior economist and strategist at money manager Lord, Abbett & Co. in Jersey City, N.J., is one observer who clearly sees it this way. "The 10-year [Treasury bond] is screaming at us that we are not going to have a second recessionary dip," he says, "and that there is no deflation issue."

For fixed-income investors, price stability is crucial to a stable bond market. Bond investors welcome neither inflation nor deflation over the long run. So the idea that bonds are signaling both falling and rising prices has been cause for consternation. Yet, special circumstances are creating these mixed signals, experts say.

SMOKE SIGNALS.

  During the late-1990s' market runups, prices of bonds and stocks mostly moved in tandem as the economy soared and the Federal Reserve deftly kept inflation in check. But a three-year bear market in equities has lured investors to bonds and upset that relationship, helping create the current confusion about whether bonds are sending the right signals about the economy's direction. Plus, rising geopolitical tensions have further pushed stock investors to the relative safety of bonds. That increased demand is driving bond prices higher and rates lower than they would otherwise be, further muddying what's normally a clear message.

Still, bond mavens point to the wider-than-normal spread between short-term and long-term fixed-income securities as the more reliable smoke signal wafting from trading desks than the level of rates themselves. The yield on 10-year Treasury bonds is now just under 4%, while that of three-month T-bills is around 1.2%. That's a difference of almost three percentage points, more than twice the historical average.

The steep yield curve more than likely reflects improving economic data. And bond watchers are buoyed by recent public statements from the Federal Reserve indicating that the central bank is willing and able to keep cutting rates to stimulate economic activity. At the same time, President Bush and Congress are fashioning a plan to increase government spending to boost the economy and help pay for the war on terrorism. That stimulus would be an inflationary force, countering any deflation risk.

"STABLE PRICES."

  David Wyss, chief economist at Standard & Poor's, thinks deflation fears are overblown. The fact that the 10-year Treasury yield is as low as it has been in 40 years reflects the Fed's easing stance, not deflationary forces, he believes. "If there were fear of deflation, the yield on the 10-year should drop further, which it isn't doing now," observes Wyss.

Agrees David Greenlaw, chief U.S. fixed-income economist at Morgan Stanley: "If the 10-year yield drops to 1%, as it did in Japan, that would suggest a deflationary problem." Instead, he says, "the 10-year yield under 4% indicates at least stable prices."

Fed officials this winter have talked in speeches about how they believe the central bank could avoid deflation by continuing to lower rates and by taking other actions if needed. If the Fed cut the federal funds rate, a key short-term rate it controls, to zero from the current 1.25%, that would make it less expensive for consumers and businesses to borrow money for buying houses or new equipment. And that would lead to increased spending and higher demand for goods and services.

THE IRAQ FACTOR.

  Conversely, in a deflationary environment, demand is nil, and businesses keep cutting prices to try to stimulate it. Further cuts from the central bank would avoid the mistake made by the Bank of Japan, which pulled back on cutting interest rates in the face of falling prices.

Of course, the war in Iraq can't be ignored, and bond prices have amply reflected that fact as investors have fled to Treasuries as a haven. If a war has a relatively quick and a favorable outcome, investors might exit the bond market in droves and return to riskier stocks. That would drive bond prices lower and push rates higher. And it would likely mark an end to the bond market's mixed signals about what's going on with the economy.

Popper is a New York-based contributor to BusinessWeek Online

Edited by Beth Belton