What The Yield Curve Is Telling Investors

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With the economy again showing signs of life, many investors are shifting their focus to the prospect of future inflation and higher interest rates. Where rates go from here has implications for everything from the value of the bonds to whether homeowners should consider locking in fixed-rate mortgages.

Such concerns are real, but when you consider that economic forecasters at Morgan Stanley and Goldman Sachs have come out with wildly different predictions on where 10-year Treasury yields are headed this year–a whopping 2.25 percentage point gap between them–it becomes clear that the average investor might be a tad challenged in getting this right.

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Rather than trying to read the tea leaves of the Federal Reserve’s latest meeting minutes, or speculating about what a glut of new Treasury bonds will do to prices over the next 12 months, we believe investors’ time is best spent listening to what the market is already saying about where interest rates and the economy may be headed. In this regard, the U.S. Treasury yield curve can be very instructive.

Yield curve 101

The yield curve plots the relationship between the interest rates and time to maturity of the entire spectrum of U.S. Treasury securities. A normal yield curve slopes gently upward, reflecting a gradual increase in interest rates as maturities lengthen out.

In a steep yield curve environment, yields climb much more rapidly than normal. This can occur when the economy is starting to pick up speed and investors’ inflation concerns cause them to sell longer-term Treasury securities, depressing the prices of those bonds and driving their yields higher.

A flat yield curve exists when the yields on short- and long-term securities are nearly identical–often an early warning sign that the economy is moving into recession. With their inflation fears quelled by the threat of recession, investors will often buy long-term bonds to capture higher yields. This causes prices of these bonds to appreciate and their yields to move down closer to short-term rates, resulting in a flattened yield curve. A flat curve can also occur following an inverted-curve environment (see below), when short rates are heading back to normal levels.

An inverted yield curve exists when short-term rates are significantly higher than long-term rates. It is often a harbinger of recession. It reflects investors’ beliefs that the Fed is keeping short-term rates too high, squeezing the money supply and increasing the likelihood of an economic downturn.

Collective Wisdom

Unlike many economic indicators, the yield curve is not produced by a government agency or private group. Instead, it is a reflection of the collective wisdom of investors on the likely direction of the economy and inflation.

It encompasses market participants’ expectations for everything from gross domestic product growth to unemployment, budget deficits, inflation, and the value of the dollar. The yield curve also “bakes in” the fiscal policy of Congress and the monetary policy of the Fed, including where the Fed sets key short-term rates (currently near zero) and its purchases and sales of securities at various points along the curve.

Over the past year, for example, the Fed has used its balance sheet to purchase longer-dated securities, particularly mortgage-backed securities, helping to keep yields down across the entire yield curve.

A Respectable Track Record

The yield curve has historically proven to be a fairly reliable economic indicator. For example, the yield curve in October 2007 was notably flat, as is often the case prior to a recession. A year later, when it seemed things could not get much worse, the curve had steepened significantly. Extremely low yields on the short end of the 2008 curve reflected considerable Fed easing to maintain the flow of capital and help the ailing economy. Higher rates on the longer end in 2008 indicated investors’ belief that the economy would pick up and rates would have to move higher to dampen potential inflation. Looking back, those curves seem to have been pretty well on target.

Back in March 2009, yields were extremely low on both the short and longer ends of the curve. Having been burned by investments in corporate and asset backed securities, investors were willing to accept less return, even on long-term bonds, in exchange for the relative safety that Treasury debt offered (not much more than 3% on 30-year Treasuries).

Since then, the yield curve has remained relatively steep, reflecting expectations that inflation, growth

and interest rates will be higher in the future, even if not in the very near term. Shorter-term rates, in turn, have dropped, reflecting investors’ willingness to accept a lower yield for now, with the expectation that they will be able to reinvest at higher rates one to two years down the road.

What’s Next?

From a portfolio strategy standpoint, investors can look at the yield curve for clues to what direction the market thinks interest rates are headed and, based on that, determine the best segment of the curve to hold. Right now, the curve’s steepness is telling us that the market, in aggregate, expects interest rates and inflation to trend higher in the future. It also reflects the collective expectations of everything from budget deficits (influencing the supply of Treasury debt on the market), to currency fluctuations (which will in part determine the relative demand for U.S.-dollar-denominated securities).

Based on the shape of the curve today, investors who subscribe to this theory may prefer four- and five-year bonds, whose expected returns are higher than those of a one-year note to compensate for the additional risk incurred by holding them. (In a flat curve environment, on the other hand, these investors would prefer one-year notes, as they would deliver similar yields to their longer-term counterparts with less risk.) Ultimately, our goal is to extend maturities when there is an anticipated reward for doing so. When you get out beyond five years, however, the risk/reward relationship starts to skew more toward the risk side of the equation and longer-term bonds start to become more correlated to stocks. That can leave an investor doubling his risk for a similar amount of return. Since we only want to take the risks for which we are rewarded, we are not moving out on the yield curve beyond five years in our client portfolios.

Rising rates and future inflation also have implications in a number of financial planning areas. For example, business owners who believe inflation is looming might consider locking in some input prices for production or operations that will take place six to 12 months from now. Individuals might think about contracting now for fixed heating oil prices for next winter, or purchasing a home or car sooner rather than later to take advantage of the current interest rate environment.

Not even the yield curve is a perfect predictor of the future. But in the spirit of the Efficient Markets Theory, it should be a good estimator of Treasury securities’ fair values given that it represents the aggregate votes of all investors and the “wisdom of the crowds.”

What the yield curve can’t capture, of course, are the risks we don’t know about. It’s entirely possible for markets to be blindsided by developments that no one could have predicted, like the Sept. 11, 2001, terrorist attacks, the Greek crisis or the BP oil spill in the Gulf.

And while markets are relatively efficient, that doesn’t mean they’re always right. In late 2008 Japan boasted a modestly steep yield curve implied expectations of higher growth and interest rates. The country has instead experienced deflation since early 2009, with seasonally adjusted GDP 7% lower at the end of 2009 than in the second quarter of 2008.

Some economists fear the U.S. may be headed for a similar plight and are more concerned about deflation than about inflation, regardless of what the yield curve is telling us.

Bucking The Trend

If you think that the market has got it wrong, you can always hedge against the conventional wisdom somewhere else in your portfolio. Hedges could range from purchasing options that would profit from a shift in the yield curve to simply keeping a cash reserve in anticipation of a future purchasing opportunity resulting from an event that is not currently priced into markets.

While it may sound self-evident, we believe that one of the most useful things investors can do is to acknowledge that while there is a lot that we do not know and cannot know about the future of financial markets, there is also a wealth of information that is often “staring us in the face”–and a lot we can do with it. The yield curve is a great place to start.

Gregg S. Fisher, CFA, CFP, gfisher@gersteinfisher.com, is president and chief investment officer of Gerstein Fisher, an independent money management and advisory firm based in New York City, www.gersteinfisher.com .

Source: www.forbes.com

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