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.
While I’m totally onboard with a trading/TAA approach to all markets overall, I keep my eye on the bond market as well, and I’m starting to get miffed at the constant mention of a painful next few years for bonds.
1992 and 2003 - coming out of recessions with interest rates at multi-year lows and with extremely steep yield curves - guess what? A GREAT time to buy the long bonds! Precisely BECAUSE the curve was so steep. When the Fed starts raising, the curve will flatten and the long end will not rise much at all compared to the short end. Seen it in the history books and we’ll see it again.
I remember hearing the arguments in 2003. How do those 10-year Ts bought at 4.45-ish percent look right now, with 3-4 years of coupons left?
Timing is EVERYTHING (as a shop devoted to TAA should know).
If someone were to ask about 30-year money and holding to maturity, I don’t know what I’d say, other than that we’ll see 5 or six business cycles before those bonds mature, and probably at least three recessions.
I’d bet strongly that buying a 10-year here, with the intent to hold to maturity, wouldn’t be so smart.
BUT buying out on the curve with the intent of TRADING it in 2-3 years, I bet that would work out quite nicely indeed, for those that are focused on fixed income.
Personally I’m long EM stocks right now, though. TAA rules!
You could be right—it is at least possible that all of the retail investors piling into bond funds could be on the right side of the market, but it hasn’t worked that way historically. Retail investors have usually been pretty good contrarian indicators. One of the things that made buying bonds with a steep yield curve in place work in some of your examples is that the U.S. was in the middle of a multi-decade secular decline in interest rates. It’s a little more difficult for me to imagine a secular decline in interest rates starting from current levels. At a conference I spoke at in October, one of the other speakers was Dan Fuss from the Loomis Sayles bond group. He felt we could be looking at a multi-decade secular increase in interest rates. If he is correct, the secular trend might not bail out bond investors this time around. On the other hand, even during a rising rate environment like the 1970s or early 1980s, it’s not that common to have big negative total returns on intermediate-term bonds. Thanks for your thoughtful comment.
From Feb 1971 to Feb 1974, the return on a 10YT was positive, because the yield on a 7YT had only risen to the coupon level of a 3-year-old 10YT. Meanwhile the short end of the yield curve rose a LOT more than the long end.
Just one example from that time period. The curve then was nowhere near as steep as now.
[...] on the Yield Curve In light of Mike’s recent commentary on how the yield curve seems to be forecasting powerful economic growth, I wanted to make you aware [...]