Little Concern About Inverted Curve

Few Wall Street phrases have proven costlier to investors than: "This time it's different." From Dutch tulips to Internet stocks, the promise of a new paradigm has generally led to financial pain rather than overflowing profits.

Keeping that squarely in mind, what's a shareholder to do when his bond fund manager swears that the recently inverted yield curve will not once again lead to an economic recession because "this time it's different"?

Well, if your solution is "ask another fund manager," don't bother. They are all whistling the same tune.

"Yes, the curve has touched on an inversion. And yes, the curve could invert further. But there are some fundamental reasons why this is occurring," says Brian Stine, investment strategist for Allegiant Funds. "And it does not necessarily foreshadow the end of the world, or even the end of the healthy economy and markets as we have known them this year."

The end of the world may not be nigh, but what has traditionally been a very good sign of financial apocalypse, or at the very least an economic downturn, appeared last week when the yield on the two-year Treasury note briefly traded above the three-year and five-year Treasuries.

The difference was roughly a basis point, which may seem like a pretty small amount to get all worked up about, especially considering it was erased when the yields soon flattened. Moreover, the benchmark 10-year Treasury bond, which is generally viewed as the yardstick when measuring curve inversion, was yielding roughly 4.4% at the time, a full 8 basis points above the two-year Treasury note.

Nevertheless, as Tony Crescenzi, chief bond market strategist at Miller Tabak and contributor, points out, every inverted yield curve since 1970 has been followed by a period in which S&P 500 earnings growth was negative, and has almost always preceded either an economic slowdown or a recession.

"Such was the case in 2000, when the inversion of the yield curve that began in January 2000 was followed by a decline in stock prices, earnings and a recession," says Crescenzi.

So even though that basis point may not have been as obvious as a burning bush, a sign is still a sign. Unless, of course, it's not a sign anymore.

"It used to be a leading indicator, but not at these yields," saysDavid Rolley, co-portfolio manager of the ( LSGBX) Loomis Sayles Global Bond Fund.

"The real question is 'what slowed the economy in the past?' Was it the shape of the yield curve or the real cost of money?" asks Rolley. "The absolute cost of money is still not prohibitively high on an inflation-adjusted basis."

The Fed Pushes Up the Short End ...

"This time is different because the Fed has been proactive rather than reactive on the inflation front," says Bob MacIntosh, co-head of muni bond funds at Eaton Vance.

MacIntosh contends that the Fed has more than done its job nipping inflation in the bud by raising the overnight lending rate to 4% via 12 straight rate hikes. The fierce lifting at the front end of the yield curve has caused a "temporary inversion" that will be fixed once the Fed stops hiking rates, according to MacIntosh.

And with each passing day it's growing all the more clear -- just look at the year-end rally in stocks -- that the Fed is getting closer to calling it quits.

Fed funds futures currently forecast a 100% chance of a 25-basis-point hike at the Dec. 13 meeting and an 86% chance of a second 25-point hike by the Jan. 31 meeting. By the time the March 28 meeting rolls around, however, the probability of a third rate hike to 4.75% drops to 54%, which is why April futures have topped out at 4.64%.

"The Fed acted early to avoid an over-acceleration of the economy, and it's worked," says Jerry Webman, director of fixed income at OppenheimerFunds. Webman doesn't see the yield curve steepening until the Fed changes course and starts cutting rates. "And they won't do that until the economy runs into trouble -- which we don't expect for a while."

Considering the growth of the economy, Webman's rosy outlook looks well founded. The Commerce Department said last week that gross domestic product rose 4.3% from July through September, up from its "advance" reading of 3.8%. GDP grew by 3.3% in the second quarter and 3.8% in the first quarter.

... While Foreign Buyers Hold Down the Long End

While the Fed was exerting all its energies pushing up short-term rates, the long end of the yield curve never seemed to get the memo that it was time to move on up. In what came to be known as "Greenspan's conundrum," long-term rates remained at record lows, keeping the yield curve flat and the Maestro perplexed.

Fund managers, and surely by now the Fed's august members, have long since realized that foreign buyers -- referred to as indirect bidders at Treasury auctions -- have been suppressing yields on the long end and will continue to do so as long as the U.S. needs to plug its massive budget deficit.

And for their part, foreign Treasury bond buyers, especially in Asia, have no qualms plowing money back into U.S. bonds -- even at rock-bottom yields -- to keep the U.S. financial system afloat, and their own export-oriented economies humming.

"This time it's different because the long end is being propped up by technical, not fundamental reasons, basically foreign buying," says Jim Hopkins, fixed-income strategist for all of State Street Global Advisors' mutual funds. "Foreign governments are regulating companies to match assets and long-term liabilities, which means they are shopping for bonds way out on the curve."

Nasri Toutoungi, portfolio manager for the ( ITBBX) Hartford Total Return Bond Fund, believes foreign interest is worth 50 to 75 basis points on the longer end of the curve. He is looking for inversion in the near future of 10 to 15 basis points between the two- and 10-year Treasury bonds. Or, in other words, with the 10-year yielding 4.49%, a reversal of more than 20 basis points from current levels.

But would that be enough of an inversion to bring about a recession, proving once again that inversion leads to a downturn? Toutoungi doesn't believe so.

Why? Because, of course, this time it's different.

"In past episodes, the overall level of rates has been 6% or higher," says Toutoungi.

When Inversion Matters

If the nearly unanimous opinion of bond fund managers is correct, and the recent inversion is not the exception that proves the rule, when would a curve inversion lead to an economic downturn?

According to Bob Gahagan, director of taxable bond investments for American Century funds, investors would have to see 10-year Treasury yields at least 50 basis points lower than two-year yields before the Fed would induce a hard landing and potentially a recession.

"I don't think the Fed will overtighten. They have a good grasp on things," says Gahagan, who views a housing collapse as the biggest macro risk to the economy when the yield curve eventually steepens.

"If the refi phenomenon is more extensive than people think, then a big jump in rates could have bigger reverberations than people realize," says Gahagan.

And considering the short-lived nature of the most recent inversion, how long should investors wait before stressing over an inverted curve that refuses to reverse itself?

Mitch Stapley, chief fixed-income officer for Fifth Third Funds, says a curve inversion lasting six months would be the cue to hit the panic button.

"It would be brutal for the financial sector because the cost of borrowing would be more than the cost of lending for too extensive a period," says Stapley.

Not that he is worried about the yield curve staying inverted for that long.

"The inverted curve is a historical anomaly," says Stapley. "It doesn't stick around."

Unless, of course, this time it's different.

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