With all of the fuss about the costs of healthcare reform, the TARP, the pros and cons of more economic stimulus, and Bernanke’s reappointment, economists seem to have taken their eye off the yield curve. I haven’t read much commentary about it at all. That’s unfortunate because the steep yield curve has a pretty dramatic message right now.
FTAlphaville has a nice article on the yield curve today that includes the graphic below:
This particular yield curve is constructed with the U.S. Treasury 2-year/10-year spread, and the spread is now at an all-time high.
It turns out that the yield curve is one of the best, if not the best, predictors of economic activity, recession, and inflation down the road. The forecasting record of the yield curve, for example, is much better than the record for various panels of economists. (For the New York Federal Reserve Bank’s FAQ on the forecasting properties of the yield curve, click here.) Pimco has a primer on the yield curve on its website which states:
A sharply upward sloping, or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will begin to rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates, which can both hurt bond returns. When inflation is rising, the Federal Reserve will often raise interest rates to fight inflation.
At the conclusion of the Fed meeting yesterday, they voted to continue the policy of keeping short-term rates low. As a result, we may see the yield curve continue to steepen. Most economists (and stock market investors) are counting on a sluggish recovery—but that’s not the message the yield curve is sending out. If the yield curve is correct, we could see much higher economic growth and much more inflation than is built into the consensus forecast.
A pundit once wrote that economists were invented to make witch doctors look good. Fortunately, I am not an economist and I have no idea what will happen to the economy going forward. However, from an investment perspective, I am quite aware of the dangers of building an asset allocation based on a wildly incorrect economic forecast. U.S. investors, by plowing enormous amounts of money into bonds and bond funds this year, are implicitly endorsing the consensus forecast of slower growth. The yield curve is saying that could be a big mistake.
As unlikely as it seems, what happens if we have powerful economic growth and rising inflation over the next couple of years? For a baby boomer nearing retirement with a portfolio loaded with fixed income it might be pretty painful. It may be that commodities or inflation-indexed securities—or another asset class entirely—will work out better. A more tactical approach to asset allocation removes the need to guess about what will happen and allows the investor to react to conditions as they change.
