Publications

What is the Yield Curve Telling Us?

Dayton Business Journal - September 2006
Expert Advice Column by Kathleen A. Carlson

Interest rates are set just like other commodity prices. The price is determined by the "market" and is based on the relationship between the supply of and the demand for the product or service. The concept is a little murky when applied to bonds. We normally talk about interest rates or bond yields, not price, and bond prices move inversely to bond yields. When the demand for bonds rises, like recently when stock investors became nervous about the market and decided to park some of their assets in bonds, prices for bonds rise and the yields decline.

Policy decisions by the Board of Governors of the Federal Reserve control the levels of interest rates on the short end of the yield curve. Investors - reacting to expectations on the future direction in such macroeconomic variables like inflation, real growth in our economy and the relative value of our dollar - set them for the rest of the curve.

Unless you've been on Pluto for the last two years, you know it's no longer considered to be a planet and that the Federal Reserve has been methodically raising the Fed Fund rate. The Fed Funds rate went from 1.0% in June of 2004 to 5.25% today. This caused yields on 30- and 90-day Treasury bills to increase by a similar amount. During the same time period, yields on ten-year Treasuries went from 4.50% to a peak of 5.25% in May of 2006 and are down to 4.80% today.

If, and when, the Fed will press the pause button on its automatic quarter-point rate hikes had been the subject of debate for months. The debate ended in August when the Board decided to adopt a "wait and see" attitude about the rate of growth in the economy and inflation. Market participants now await every statistical release looking for indications of an economic slowdown.

As expected, we have pundits on both sides of the aisle. Most of them feel we are in the midst of an economic slowdown, but some believe it is only temporary, and when growth resumes, so will the need for further rate hikes. While others believe the current weakness will ultimately lead to a recession.

The yield curve appears to support the latter. In the last two years the 6-month Treasury bill was always higher than the Fed Funds rate, meaning investors expected the Fed to raise rates at some point in the future. Today, interest rates all along the curve are below the 5.25% Funds rate indicating a belief that the next move by the Fed will be a rate cut. At 5.16%, the 6-month Treasury bill says a rate cut would at least be three months out.

Looking at a 30-basis point spread between the one-year Treasury note at 5.07% and the five-year Treasury note at 4.77%, we see that bond investors expect to see a meaningful slowdown in our economy. The last time the one-year was above the five-year Treasury was in the summer of 2000, just prior to the beginning of the recession, when it was a negative 24 basis points.

But, before we press the panic button, a negative spread between the one- and five-year occurred in 1989 and a recession did not immediately occur; however, it certainly bears watching.

Investors would like, what is being described as, the Goldilocks scenario to unfold, where the rate of economic growth slows and future growth is not too hot and not too cold. They look back to 1994/95, the last time the Fed correctly engineered a "soft landing", as a hoped-for model for the market to emulate. Intermediate-term interest rates peaked in November of 1994 and economic growth hit bottom six months later, slowing to a one percent rate. Stock prices moved steadily higher throughout the entire period managing to look past the slowdown to the Goldilocks environment that followed.

We hope the yield curve believes in fairy-tale endings.