Stocks Echo Flattening Yield Curve

The indices sit tight as the gap between the two- and 10-year yields goes below 10 basis points.
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The bond market, it seems, sees eye to eye with

Fed

chairman nominee Ben Bernanke's views on inflation, and has taken solace in his implied pledge to continue to hike short-term interest rates.

So much so that the yield curve, which plots the yields of Treasury securities ranging from the shortest to the longest, is flattening. The flattening was dramatic Wednesday after news of tame core consumer price inflation and a report showing foreign purchases of long-term U.S. securities hit a record in September.

The combination led the benchmark 10-year Treasury bond to jump 21/32 while its yield, which moves inversely, fell to 4.48%.

As a result, the spread between the yield of two-year and 10-year Treasury notes fell below 10 basis points for the first time since 2000. The spread between the yields of two-year, three-year and five-year notes is almost nonexistent, with their yields at 4.40%, 4.41% and 4.42%, respectively.

An inversion of the curve -- when the yields of short-term notes are higher than those of long-term bonds -- seems increasingly likely in the months to come, if not sooner. An inverted yield curve typically augurs a recession, which may explain why falling bond yields didn't help stocks much Wednesday.

The

Dow Jones Industrial Average

fell 11.68 points, or 0.11%, to 10,674.76. As crude oil prices rose 90 cents to $57.88 a barrel,

Exxon Mobil

(XOM) - Get Report

rose 1.3%, helping the blue-chip average. But the Dow was weighed down by a 5.8% decline in

General Motors

(GM) - Get Report

and a 1.7% drop in

American Express

(AXP) - Get Report

, which said that analysts' fourth-quarter growth estimates were "far too aggressive."

Higher energy shares did help the

S&P 500

rise modestly, adding 2.20 points, or 0.18%, to 1231.21. The

Nasdaq Composite

fell 1.19 points, or 0.05%, to 2187.92.

It's Different This Time

During his confirmation hearing on Tuesday, Bernanke said that unlike the oil-spike induced recessions of the 1970s, the U.S. economy currently remains sheltered from recession by "well-anchored inflation expectations."

By this he meant that as economic actors expect inflation to remain low, this has helped prevent the most recent spike in energy prices from seeping to core inflation. Therefore, "the Fed has been able to raise rates to 4.0% and the economy has still been able to grow strongly," Bernanke said.

As if on cue, both the October producer price index on Tuesday and the consumer price index on Wednesday showed increases in headline inflation but little change in core inflation.

At the same time, however, Bernanke confirmed that he shared the Fed's determination to continue lifting short-term interest rates to contain inflation pressures. "Currently, inflation is above the range which in the long run would be desirable," he said.

And so short-term yields should continue rising to reflect expectations that further rate hikes are on the way. At the same time, however, there are increasing expectations that the higher rates, together with high energy costs and a slowing housing market, will slow the economy next year.

Whether this implies a recession or not is debatable. Tony Crescenzi, interest rate strategist at Miller Tabak and a

RealMoney.com

contributor, says that the yield curve's track record at predicting both a recession and negative earnings growth has been stellar since 1970.

However, he notes that the correlation has been most accurate when it is the yield of three-month Treasury bills that fall below that of the 10-year. Currently, that spread is 48 basis points, compared with 61 basis points on Aug. 30.

According to yield curve/recession correlation table by Fed economists Arturo Estrella and Frederic Mishkin, such a spread currently predicts 15%-20% odds of an economic recession in 12 months. That's up from 12% on Aug. 30, but still not a given.

Tellingly, the corporate bond market is not showing any sign of panic at the prospect of an inverted yield curve, according to John Atkins, a corporate-bond strategist at IDEAGlobal. Presumably, the prospect of negative earnings growth should increase the chances of bankruptcies and send the yields of corporate bonds most at risk sharply higher.

As the yield curve showed an increasing flattening pattern over the past few sessions, the only area that corporate bond players have kept "a nervous eye on" is the financial sector, which remains the most susceptible to the impact of a flattening or inverting yield curve.

Banks especially make money by borrowing shorter term and lending for the longer term, usually at higher rates. A flat (or inverted) yield curve can dramatically decrease or eliminate this profit formula, called the carry-trade.

But according to Atkins, not even the bonds of

Capital One

(COF) - Get Report

, among the most susceptible because it heavily relies on the carry trade, moved much at all on Wednesday.

Interestingly, though not surprisingly, most of the jitters lately in the corporate bond arena have been seen in the bonds of homebuilders, ever since

Toll Brothers

(TOL) - Get Report

warned that a cooling home market would hit profits, Atkins says.

Toll's shares rose 1.6% on Wednesday, however, gaining along with fellow homebuilders

KB Home

(KBH) - Get Report

and

Pulte Home

(PHM) - Get Report

, which rallied after

DR Norton

(DHI) - Get Report

posted a 61% increase in profits and raised its outlook. The Philadelphia Housing Sector Index rose 1.1%.

Still, the biggest question facing the economy next year is whether a cooling housing market -- together with higher energy costs and higher interest rates -- will slow consumption sufficiently to present a risk to economic growth.

Given the shape of the yield curve, it seems the bond market is increasingly expecting an affirmative answer to that question even if some observers, Bernanke most notably, believe the yield curve isn't the same barometer of economic health it once was.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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