Ahead of the Curve: Bond Market Is Predicting Economic Recovery

Don't think the economy is going to recover? The bond market would disagree with you.

For most of 2000, the bond market was signaling that the economy was headed for a significant slowing in economic growth. Then, nobody was listening. Sure enough, the economy began to decline a short while later.

"Last year, it was the first market to say, 'Hey, this is it,'" says Mike McGlone, vice president in trading at Aubrey G. Lanston.

Now, the yield curve -- the difference in yield between specific Treasury securities -- is signaling that recovery is on the way. One of the key measures of the yield curve, the comparison between the three-month bill and the 10-year note, reverted to a more normal slope four months ago. But in the past week, the short end of the curve -- that is, the difference between the three-month bill and the two-year note -- has also reverted to a normal slope.

What that portends, according to economists, regardless of how ugly the Nasdaq still looks, is that the economy is going to recover and come back to a period of growth a few quarters down the road.

The yield curve is an expression of the difference in yield between two Treasury securities of a varying maturity. Naturally, one would expect an investor to assume greater risk on a longer-dated security, because there's more uncertainty about what might happen 10 years down the road than in three months. So when the yield curve is positively sloped -- that is, when shorter maturities yield less than longer maturities -- it's a decent indication that the economy will be growing in coming quarters.

However, when it inverts, it's a sign that the economy could be headed for hard times. That's because when investors are demanding a higher yield for a shorter-dated security, they feel there's greater risk in coming months than, say, in a decade or two or three.

Inversion ... and Reversion Yield Spread Between Three-Month Treasury and 10-Year Treasury

Source: Baseline

The spread in basis points between the three-month bill and the 10-year note inverted in July 2000. Quite a few people chalked up the inversion to supply issues -- the government drastically reduced its sale of long-dated securities, and strategists pooh-poohed the inversion, saying it wasn't a harbinger that the economy was slowing.

As it turns out, this indicator was an accurate one, as the economy slowed dramatically in the fourth quarter of 2000. Worry that the economy will fall into recession remains, but this is at least a signal that recovery is on the horizon. This spread reached its nadir at the end of the year, when three-month bills briefly yielded an additional 90 basis points, or 0.9% more than the 10-year note. (A basis point is equal to 1/100th of a percentage point.) It reverted to a normal slope in late January.

A 1996 Federal Reserve study shows that the yield curve is one of the most accurate forecasters of economic growth and decline, and certainly a better "tell" than the stock market. In the fourth quarter of 2000, the yield spread averaged -0.61%, putting the chances of a recession in the coming two to six quarters somewhere between 40% and 50%, according to the Fed. The average spread for the first quarter -- 0.23% -- still puts the recession odds at around 20%.

Fed in Market's Head

Within this reversion, there's been some interesting permutations in the past few days in the shortest part of the yield curve. This part of the curve -- that is, the three-month bill to the two-year note -- became inverted late in 2000 and remained so until the past few days. That's not good: It means banks are paying more money to borrow short-dated paper than to lend slightly longer dated paper, and that's going to inhibit lending because they don't want to lose money on such transactions.

But that worm turned in the past week as a result of a massive selloff in two-year notes. What caused this? A selloff in the fed funds futures contract, the market's best indicator of what people think the Federal Reserve is going to be doing in coming months.

The fed funds contract has been pulling back in recent days, as investors no longer believe the Federal Reserve is going to cut interest rates prior to the May 15 meeting. Two-year notes react sharply to expectations for changes in Fed policy, and the yield on those notes has pulled back to 4.06% from 4.26% in just a week.

Analysts disagree as to why this happened. McGlone at Lanston says this took place because the Fed did not immediately react to the weak March employment report. Also, Fed officials, in a seemingly clone-like way, have gone out of their way to make clear that the Fed prefers to make changes in policy at the meetings.

However, Jim Bianco, president of Bianco Research, believes it's all about the stock market. While Alan Greenspan and his cohorts may not be explicitly targeting the stock market, he says a major factor in the selloff in fed funds, and by extension, two-year notes, was because the Dow Jones Industrial Average rebounded to 10,000 earlier in the week.

"Greenspan would swear on truth serum that he's not following the stock market's lead, but that's not the way the market is doing it," he said. "It's taking its lead from the stock market. So by transitory logic, he's following the stock market."