Don't Be Thrown By The Yield Curve

The words "inverted yield curve" used to send Wall Street into a panic. In the normal state of affairs, the yields on longer-term Treasury bonds are greater than those on shorter-term Treasuries to compensate investors for taking on longer-term risk. When the curve inverts, the yield on short-term Treasuries is higher. This rare event -- the last inversion was in 2000 -- has preceded the past six recessions.

But a funny thing happened when the yield curve reversed during the last week of December: Few people paid attention. Stocks dipped, but the sell-off was nothing that would indicate widespread recession fears.

Many economists say the latest inversion won't lead to recession because short-term interest rates are relatively low compared with past inversions, meaning consumers and businesses can still get credit at historically attractive terms. And some economists, including those at the Federal Reserve, argue that long-term yields have been artificially depressed by foreign investors, who have been buying longer-term Treasury bonds voraciously. Strip away the foreign buying, they say, and long-term rates would be far higher.

Don't bury the yield curve just yet, however. It might not be the harbinger of recession it once was, but changes in its slope still affect certain sectors. The latest inversion, say analysts, could hammer housing-related companies because home-loan costs are rising for some borrowers. The adjustable-rate mortgages (ARMS) that have fueled the booming coastal markets for three years are getting pricier as short-term rates jump. "The advantage of an ARM over a fixed-rate mortgage has largely been taken away given that the yields are [almost] equal," says Jim J. Fowler, an analyst at JMP Securities LLC in San Francisco. With ultra-low financing drying up, more buyers will be priced out of the housing market in 2006 -- bad news for homebuilders.

Some inversion cycles last only a few days. But with the Federal Reserve expected to raise the federal funds rate to 4.5% when it meets on Jan. 31, the current cycle could linger. Michael Moskowitz, president of New York-based mortgage bank Equity Now Inc., says an inversion that lasts four weeks or longer will hurt mortgage lenders. Michael Benhamou, a managing partner at Louis Capital Markets LP in New York, points to US Bancorp (USB ), Fannie Mae (FNM ), and Freddie Mac (FRE ) as likely losers.

The downward curve isn't bad news for all corporate balance sheets. Producers of capital equipment should benefit from low long-term borrowing costs. If economic growth continues at something near its current pace, many companies will increase capital expenditures financed with cheap credit. "We're expecting a solid year for equipment and software spending," says Michael R. Englund, chief economist at research firm Action Economics LLC. "Businesses seem to have very optimistic plans for investment in 2006."


Big companies that can tap the public-debt markets rather than resort to bank loans should benefit most, says Edward Yardeni of Oak Associates in Akron. General Electric Co. (GE ) is ideally suited, with access to the capital markets to fund its own growth and tons of capital equipment to sell to others, says Larry J. Puglia, manager of the T. Rowe Price Blue Chip Growth Fund. "It's at the head of the class of the large caps that will do fairly well almost regardless of the economy."

Companies that sell equipment and services to the energy industry also stand to gain. Years of shrinking refining capacity caught up with U.S. oil and gas producers in 2005. Rebuilding refineries and energy distribution centers in the Gulf will account for some of the largest outlays this year, especially if low long-term interest rates persist. Henry "Chip" Dickson, chief U.S. strategist at Lehman Brothers Inc., estimates that the sector will boost its capital spending by 15% in 2006.

Another beneficiary of the flat-to-inverted yield curve: ordinary investors. According to Bankrate Inc. (RATE ), the top one-year certificates of deposit offer an annual percentage yield of around 4.9% -- just shy of the 5% you can get for a three-year CD, but without having to lock up your money for as long. After years of paltry short-term CD yields, 4.9% looks pretty good.

By Roben Farzad and Justin Hibbard

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