I have respected the message of the yield curve this year, but have never found reason to think the curve was signaling recession. It is interesting to think that the move toward inversion was something the bear camp mentioned as far back as nearly two years ago, when the yield spread between 10- and two-year Treasuries started narrowing at a faster pace. The chatter picked up further in August 2005 when the spread was almost zero (it inverted in December 2005).
Anyone who let those moves dictate their decisions on equities bet wrong. I recognize that the yield spread between T-bills and 10s is more important, but I want to point out that fears about the yield curve's move toward inversion has actually been a feature of the markets for quite a while.
I still believe that the yield curve provides important information about expectations on the economic outlook. I nonetheless feel that in this current situation, the yield curve's message should be watered down a bit compared to past inversions for the following reasons:
The current inversion is occurring with long-term rates much lower than what was in place just prior to the past five recessions. Low long-term rates should help to prevent recession.
Interest rate volatility is much lower today relative to the past few decades, which is contributing to the low level of long-term rates. There are several reasons for the reduced volatility, including the smoothing out of economic cycles, which is related to many factors, such as better inventory controls and improved monetary policies.
The following point is debatable, but I believe that the sharply increased use of derivatives reduces risks associated with interest rate volatility, and that this results in lower long-term rates. Today there are $370 trillion of derivatives outstanding, an increase of about four times over the past five years. Those with interest rate exposures now have greater comfort in managing their interest rate risks. Holders of junk bonds can feel likewise if they buy protection against default in the credit default swaps market.
Tax rates on capital gains are at their lowest since World War II. The lower tax rate provides important support for the equity market and the economy.
The Fed's credibility is arguably at its highest in over 40 years. This is helping to keep long-term rates low.
Global liquidity is a factor of unprecedented proportions driving long-term rates lower than they would otherwise be and, hence, distorting the apparent message inherent in the yield curve regarding the economic outlook. China's reserves, for example, are now $1 trillion compared to just $200 billion five years ago. Russia's reserves are close to $300 billion compared to just $10 billion in 1998. Total dollar deposits have increased about $1 trillion each of the past two years. Some studies put the impact of central-bank buying on 10-year Treasury yields at as much as 75 basis points.
The global economic expansion is the sturdiest in 30 years, and this should buffer both the U.S. economy and U.S. equities.
Take note that today's inversion can disappear very quickly, and it might be too late to act on the inversion. What's next could be a sharp steepening of the curve. In December 2000, the spread between 10s and bills was -100 basis points. Four months later, the inversion was reversed, and the spread was +150.
P.S. Will you be there when Cramer makes his next move?
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Tony Crescenzi Blog Money Growth Quickens 12/29/2006 10:03 AM EST The Fed could have more mopping up to do if economic growth accelerates.
Tony Crescenzi Blog Bonds Close Early 12/29/2006 9:12 AM EST Here's what the Treasury market will be watching next week.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.
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