The US Bond Market's Inverted Yield Curve

Traditionally, an inverted yield curve, a condition in which short-term securities offer higher yields than long-term instruments, has been interpreted as an indicator of a coming recession. An inverted yield curve last occurred in January 2000, and preceded our most recent recession that began in March 2001. This phenomenon has also occurred prior to the recessions of 1990, 1981, 1980, 1973, 1969 and 1960. So, statistically, the odds would seem in favor of a recession in the near future.

However, a global economy and other factors are changing these odds, calling into question the predictive value of a flat/inverted yield curve. The bond market continues to attract record levels of foreign investment, despite the relatively low rates at longer maturities. From 2001-2005, foreign holdings of US debt obligations (Treasuries) increased from $151bn (17 per cent of total US debt) to $2,024bn (nearly 50 per cent of total US debt).

Much of these capital flows come from Asia, where the priority is to ensure continued growth in their export economies. Buying Treasuries with the inflows of dollars keeps their currency low, fueling demand in the US for low-cost imports.

Ageing baby boomers may also be contributing to lower long-term yields. According to US Census Bureau figures, the percentage of the US population 65 years old or more will jump to 20 per cent by 2030 from 12.4 per cent in 2000. The ageing of the European population will be even more pronounced, with 23.5 per cent of the population 65 years old or older by 2030, from 14.7 per cent in 2000. As the first baby boomers turn 60 this year, continued demand for fixed income investments would seem likely, as this population rebalances their portfolios for greater safety.

Pension funds may have an increasing influence on the bond market as well. Congress is in the process of crafting legislation that would require companies to fund their pension plans in a way that favors bond investments. And a recent study conducted by Citigroup showed that pension funds need about $150bn in debt with maturities 10 years or longer to fully fund their pensions.

With an understanding in place of the demand for US debt, one must look to the supply side for indicators. To finance the budget deficit and hurricane re-building efforts, the government has borrowed $181bn in the first quarter of 2006. Time will tell whether this additional capital flow will increase long-term yields, and steepen the curve.

But if the Treasury auctions during the first full week of February are any indication, the impact could be minimal. That week the Treasury auctioned $21bn of three-year notes, and $13bn of 10-year notes, respectively. It also auctioned $14bn of 30-year bonds for the first time in five years. Prices for the 30-year surged, drawing a yield of 4.53 per cent, the lowest on record for this issue.

Beyond the increasing global demand for US debt, another fundamental difference today is how the Fed is managing monetary policy relative to inflationary pressures. In many of the prior periods where recession followed an inverted yield curve, interest rate inversions were the result of the Federal Reserve’s willingness to risk a recession to stamp out inflation.

Today, however, the Federal Reserve’s goal is a soft landing, as evident by the relatively low real short-term rate of 2.3 per cent. This real rate (short-term rate minus inflation) has topped 4 per cent prior to every recession since 1973. The Fed’s gradual 25 basis point increases, along with the measured language in its statements, suggest an aversion to recessionary risk at this point.

The range of dynamics influencing today’s interest rate environment make for an interesting and sometimes confusing experience for fixed income investors. This conundrum, as Alan Greenspan, previous chairman of the Federal Reserve, described it, is causing many analysts and economists to re-evaluate their interpretations about the current yield curve.

Despite the convergence of all these global events, which are affecting the yield curve, business owners and managers can still find ways to manage finances. If they have extra cash, they should consider short-term investments, as there is little if any benefit from assuming risks inherent further out on the yield curve. However, we are nearing the peak of the rate cycle, so they need to keep an eye on signs of the Fed decreasing rates going into 2007, as this will reduce short-term yields.

Business owners and managers whose firms are net borrowers should evaluate their debt structures, with respect to the rates being paid and the maturities. They may benefit from the flat yield curve by refinancing their debt and locking-in relatively lower yields.

The bottom line when navigating uncertain market currents is measuring the added benefit of taking on incremental risk. Our current rate environment is not rewarding long-term investors or short-term borrowers. However, the markets will eventually revert back to the mean. Therefore, at some point, the yield curve will return to a more normal slope, either through an increase in long-term yields, a reduction in short-term yields, or some combination of the two. But regardless of what the market does, your understanding of these dynamics will enable you to evaluate the risks and maximize returns in any environment.