Why You Should Follow the Movement of the Treasury Bond Yield Curve - TheStreet

Why discuss the yield curve now?

The Treasury yield curve -- don't worry, I'm going to explain what it is -- has undergone an interesting and potentially significant shift this week. The 30-year Treasury bond's yield is once again higher than the 10-year Treasury note's yield. That is usually the case, though it hasn't been lately. This chart shows what happened.

Lower No Longer
The 30-year Treasury bond's yield moved higher than the 10-year note's this week for the first time since January.

What is a yield curve?

A yield curve is a graph that plots the yields of bonds of a certain type, from the shortest-maturity issue to the longest-maturity one, at a point in time.

The Treasury yield curve, for example, graphs the yields of the two-year note, the five-year note, the 10-year note and the 30-year bond.

There are as many yield curves as there are types of bonds. The corporate yield curve plots the yields of corporate bonds; the municipal yield curve plots the yields of municipals bonds. But the Treasury yield curve is simplest because Treasury bonds and notes come from just one issuer -- the U.S. government. Each point on the corporate yield curve, for example, would average together the yields of corporate bonds from a variety of issuers.

Normally, the longer the maturity of the bond, the higher the yield investors demand, because of the difficulty of forecasting what might happen over a long period of time.

So a normal yield curve looks like this:

A Normal Yield Curve
The Treasury yield curve on Dec. 31, 1999

Because bonds make fixed payments, investors value them based on how much they expect inflation to erode the value of those fixed payments. The higher their expectations of inflation, the less they will pay for bonds. The lower they expect inflation to be, the more they will pay. And in bondland, lower prices correspond to higher yields, and higher prices correspond to lower yields. When prices fall, yields rise, and vice versa.

An investor might buy a two-year note at a yield of 6% because he is confident that over the life of the note, inflation, currently running at 3%, will not double to 6%, eroding the value of the note's payments. But the same investor might demand a yield of 7% on a 10-year note, because of the difficulty of forecasting what might happen down the line.

Why should I care?

You should care about the yield curve because it encodes a message. It betrays what bond investors expect in the way of inflation (arising from what they expect from the economy, and with obvious implications for all kinds of investment).

The higher the yields investors demand on long-maturity bonds, compared with yields they demand on short-maturity issues, the more worried they are about inflation accelerating. When inflation is accelerating, you don't want to be holding long-maturity bonds. You want your money back quickly, so you can spend it before it loses its value. So long-maturity bonds have to offer high yields to entice investors to buy them.

A little inflation is normal. That's why it's normal for yield curves to slope upward. But a steepening yield curve -- long-term rates rising relative to short-term rates -- may signify growing concern about the potential for the inflation rate to rise.

Yield curves also can slope downward, with short-term yields higher than long-term yields.

When investors think the inflation rate will drop, and maybe even turn into deflation, they become willing to buy long-term bonds at lower yields than short-term ones.

Consider: In the event of deflation, in which prices fall because demand is weak, the

Fed would cut short-term interest rates to stimulate economic activity. In that case, short-term bond yields would fall in tandem, once again dropping below long-term yields. Investors in short-term bonds would face the prospect of reinvesting at those new lower rates. If they had bought long-term bonds they would not face that problem.

When long-term yields are lower than short-term yields, bond market participants say the yield curve is inverted. The most egregious example of an inverted Treasury yield curve occurred in 1981, when short-term yields briefly exceeded 15%.

The Treasury yield curve inverted in January 2000, and remained inverted until this week. Here, for example, is the Treasury yield curve on Aug. 31:

An Abnormal Yield Curve
The Treasury yield curve on Aug. 31, 2000

The January 2000 inversion was a special case, however. It was partly due to economic expectations. The Fed had been hiking interest rates, putting the brakes on economic growth and curbing the risk of inflation. But for the most part, this inversion was a supply phenomenon.

The

Treasury Department

announced an initiative to use federal government surplus funds to pay down the national debt by buying back Treasury securities from investors. The government's buybacks would target the longest-maturity issues, which carry the highest interest rates. The prospect of a shortage of long-maturity Treasuries drove their prices higher, causing their yields to fall below the yields of short-maturity issues. The theory is: If you think that long-term Treasuries -- the 30-year bond in particular -- will continue to go up in price based on scarcity, then no yield is too low to accept.

What does the Treasury yield curve look like now?

By most measures, the yield curve is still inverted. The two-year note is the highest-yielding issue, followed by the five-year note. But for the first time since January, the 30-year bond's yield is once again higher than the 10-year note's yield. So, we have a yield curve that looks like this:

A Partial Disinversion
The Treasury yield curve earlier today (Sept. 15, 2000)

What's going on?

The 30-year bond's price has been falling -- fast. As a result, its yield has risen sharply.

The 10-year note's price has also been falling, but not nearly as much. So as the first chart showed, its yield hasn't risen as much.

By contrast, shorter-term yields have been relatively steady.

Just as the initial inversion of the Treasury curve was largely a supply phenomenon, the disinversion we have begun to witness also has much to do with supply.

With Election Day approaching, bond investors are reassessing the probability that the federal government will continue to run large surpluses, regardless of who wins the White House. If the surpluses are smaller, buybacks of long-maturity Treasuries will proceed at a slower pace, if at all.

Also, issuance of new corporate bonds was especially heavy this week. Corporate bond issuance can prompt selling of similar-maturity Treasuries, and this week's slate included at least one 30-year corporate bond.

Liquidity in the 30-year Treasury bond is poor. It's volatile, it's in short supply, and so compared with shorter-term securities, it doesn't have as large a group of people willing to buy and sell it. As with any illiquid security, that means that when the selling starts, the price moves lower, fast.

But at the same time, this may mark a shift in investor sentiment, arising from concern about the economy and inflation. The principal causes for concern are high oil prices -- crude oil is topping $35 a barrel for the first time in 10 years -- and the weakening euro. By selling long-term Treasuries, investors may be recognizing the potential for these forces to have a crippling effect on economic growth, one that could eventually prompt the Fed to cut interest rates.

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