The Yield Curve - An Investors Crystal Ball
By: Jon Heckscher, Portfolio Manager, LOM Asset Management Limited
September 1st, 2007 - The bond market has a crystal ball and the equity markets should take notice... The yield curve.
For decades it has helped to foreshadow major events and turning points in both the financial markets and the economy. Whilst the yield curve is of course a product of the bond market, this does not mean that it’s usefulness is confined to bond investors alone. Indeed, given the broad array of events that the yield curve has forecast, it deserves serious study by all investors.
The events of the past year have once again proven the value of using the yield curve as a predictor of the future economic and financial events. Investors that took notice of the yield curve in 2006/2007 profited. Those who failed to do so will know what a deer caught in a car’s headlights must feel like.
The economic events that have unfolded were forewarned by the inversion of the yield curve in February 2006 for the first time in five years. At first glance an inverted yield curve seemed like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?
The answer is that long-term investors will settle for lower yields now if they think rates — and the economy — are going even lower in the future. They’re concluding that this is their last chance to lock in rates before the floor gives way. While inverted curves are rare they should never be ignored. They are almost always followed by an economic slowdown, or outright recession, as well as lower interest rates across the board.
These conditions, although more obvious, were also in place prior to the economic slowdown of 2001. As the economy slowed, rates were lowered as an attempt to stimulate the economy. Buoyed by consumer confidence, many analysts felt the economy had toughed in early September. It appeared that although numbers were weak, the US would be able to avoid recession. Although the terrorist attacks drove the yield curve lower, the economic output that was derived from the reconstruction and military fortification had the economy humming within 18 months (GDP growth was near 4% in 2003)
Fast forward to the present and a similar aura is hanging over the markets. As the yield curve inverted last year, many pundits immediately called for doom and gloom. Much to their dismay, the economy, led still buy the resilience of the consumer kept the train on the track. Although growth had slowed markedly by the first quarter of 2007, many economists (LOM included) thought there was light at the end of the tunnel.
Unfortunately, the Sub Prime market which makes up an estimated 15% of the total 10 trillion dollar US mortgage market has become an epidemic which is threatening to spill over from a housing recession to a general recession. From the actual poor credit loans, to the companies that lent the money, to the institutions that now hold it in the form of a bond, the entire market is reeling from this crisis. The market will eventually return to normal, but volatility will reign supreme for the next few months.
Historically the financial markets have irrationalized various themes within every economy. From the tulip mania of 17th century Netherlands to the dot-com era of the late 1990’s, the over exuberance that accompanies greed and wealth has always resulted in a POP to a bubble. What has happened over the last month is no exception.
As it became evident that the housing market was slowing (late last year), portfolio and risk managers began to assess potential risks within their portfolios. To avoid corporations that may potentially have sub prime risks on their books (through direct or indirect business), investors sold these companies in favor of risk free securities issued by governments. As this one way flow became more obvious, the market quickly dried up as buyers pulled out of the market. As a result, the Capital market ground to a halt in mid August.
As the markets move fretfully from summer to autumn, the eyes of the financial world will be on all things housing. From the global banks to the small town savings and loan, it will be imperative that the liquidity returns to the market before a recession sets in. Banks need to reestablish institutional confidence by resuming inter-bank lending and the central bank needs to lower its target rate to allow for the general economic activity to continue. Although these issues should come hand in hand, we will have to wait and see who will lead who. Until then, the financial quagmire will continue and volatility will remain high.
As long as stocks remain volatile, bonds should benefit. Yields have already tested recent lows. We anticipate the flight-to-quality response from the financial markets to continue, while corporate spreads could widen further as foreign investor’s trickle out of the US markets and portfolio managers continue to avoid names that may have housing skeletons in the closet.
Historically, the yield on 30-year Treasury bonds is one to two percentage points above the yield on three-month Treasury bills. When it gets wider than that — and the slope of the yield curve increases sharply — long-term bondholders are sending a message that they think the economy will improve in the near future. Conversely, when the spread is less than one percent (a flat yield curve) the prospects for the economy become negative. Ultimately a negative spread (an inverted yield curve) points to doom and gloom for the economy. Although the recent events are atypical, the steepening is quite apparent. Three month T-bills are yielding 4.20% while the 30-year Treasury is yielding 4.77% (this was inverted in May).
A steep curve is typical of that found at the beginning of an economic expansion, just after the end of a recession. At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is reestablished by growing economic activity, rates begin to rise.
Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk. Short-termers can trade out of their T-bills in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise.
In October 2001 (the end of the last mini- recession), the spread between short and long-term rates was three percentage points, indicating that the curve was anticipating a strong economy in the future… The curve was correct as GDP was expanding at three to four percent per year in 2003 & 2004. By June 2006, short-term interest rates (which slumped to historical lows right after the 2001 recession) had jumped four percentage points, flattening the curve into a more normal shape. Equity investors who saw the steep curve in 2001 and anticipated economic expansion were richly rewarded.
If the shape of the current curve continues to steepen, look for the economic conditions in the United States to rebound from their current levels. Conversely, if the curve ‘flattens’ (spread narrowing) look for the economy to get worse. For the month of August, the curve steepened by more than 60 basis points (on August 1st the spread was 0.03% and on September 1st it was 0.657%). Although the curve is still considered flat (i.e. danger pending), the steepening that has occurred recently points to the economy possibly skirting an outright recession. If the spread shrinks markedly over the coming weeks and months, look for the housing recession to take hold as a general recession.
Although the factors of the past month are significantly different to those the markets have faced before, the markets are resilient and the crystal ball (the yield curve) will continue to be an accurate forecaster of economic conditions.
