Bond Yields: A Curve Ball for Economy?

The bond market, which can be prescient about the economy’s direction, is starting to signal that the Federal Reserve may be succeeding in its efforts to slow growth, some analysts say.

A recent shift in Treasury bond yields--with 30-year yields now below yields on 10-year securities--suggests that investors are betting on two things: another round of short-term-rate increases by the Fed, but in the longer run continued moderate inflation and lower interest rates.

At least, that’s one interpretation of the rate shift, which is an unusual event in the bond market.

Some analysts also worry that the shift could be warning that the U.S. economy, despite its strength, is particularly vulnerable to any unforeseen shock.

“I’m kind of on alert for something to break here,” said Scott Grannis, economist at Western Asset Management in Pasadena.

He argues that the Fed’s tighter-money policy, in the relative absence of inflation, is putting undue pressure on the economy.

Bond investors’ expectations for trends in the economy, interest rates and inflation are reflected in the so-called yield curve, which simply plots yields of various Treasury securities, from short-term to long-term, on the same graph.

A normal yield curve slopes upward--that is, the longer a bond’s term, the higher its yield, to compensate investors for the greater risk in locking up their money for a longer period.

Recently, however, there has been a pronounced flattening of the curve, with yields on medium-term bonds at nearly the same level as, or even higher than, longer-term ones.

The annualized yield on the benchmark 30-year T-bond, for example, closed at 6.72% on Wednesday, while the 10-year T-note yielded slightly more, at 6.73%.

An “inverted” curve, in which shorter-term yields are actually higher than the longest-term ones, historically has been a signal of a weakening economy: It suggests some investors believe that short rates have gotten high enough to slow the economy sooner rather than later--at which point investors often rush to lock in yields.

But so far, 30-year T-bonds still pay more than, say, 2-year T-notes. The difference between the two is shrinking, however: It now is 0.27 of a percentage point, down from 0.43 of a point as recently as Oct. 1.

“Most economists would not [yet] regard this as a classic warning of recession,” said Richard D. Rippe, chief economist at Prudential Securities.

Tony Crescenzi, bond strategist for Miller Tabak Hirsch & Co., said the current inversion between 10-year and 30-year securities in part reflects supply issues.

Because the government is no longer running huge annual deficits, issuance of 30-year T-bonds is down, he noted, while the supply of 10-year T-notes and corporate bonds is plentiful. When there is a relative oversupply, yields must rise to attract more investor demand.

Crescenzi said he won’t be sure that an economic slowdown is in process until yields on 2-year T-notes and even shorter instruments match the level of the 30-year bond.

Still, “The fact that we’re nearing parity or inversion means we’re getting close [to a slowdown signal],” he said.

The last yield curve inversion came in the late summer of 1998, after the Russian bond default sent investors scurrying to the safety of Treasury securities. That caused long-term yields to tumble, but only temporarily.

Bruce Steinberg, economist at Merrill Lynch, believes that if an economic slowdown is on the way, it will occur toward the end of the year.

The global economy is still picking up steam and, as for the United States, “there’s still a lot of strength out there,” Steinberg said, noting a report Wednesday indicating that housing construction had surged in December.

Others disagree. Brian Wesbury, economist at Griffin, Kubik, Stephens & Thompson in Chicago, thinks there are subtle signs of weakness in the economy. He sees the strong December construction figure as mainly a quirk of last month’s mild weather.

In any case, the overall trend in bond yields indicates that investors are nearly certain that the Fed will continue pushing short-term rates higher. The only question is how many rate hikes are foreseen.

Grannis thinks the market has “priced in” a full percentage point of Fed tightening between now and Labor Day, which would push the federal funds rate--the overnight bank loan rate that the Fed essentially controls--from the current 5.5% to 6.5%.

Others believe the market so far reflects an increase of only half a point in the Fed funds rate to 6%.

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Signaling a Slowdown?

The yield on 30-year Treasury bonds has dipped below the yield on 10-year Treasury notes--an unusual event that historically signals an economic slowdown. How the so-called yield curve has changed since Oct. 1:

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Sources: Reuters, Bloomberg News