In the latest example of how the financial crisis is causing economists to question everything they held dear, many are suddenly distrustful of what has traditionally been a reliable predictor of turns in the economic cycle.
The yield curve, which measures the difference between the interest rates on shorter versus longer term government debt, heralded economic expansions in the United States in the early 1980s and the early 1990s. It also predicted the latest downturn, although few analysts paid attention at the time.
Right now, the yield curve is extremely “steep” – that is, longer-term rates are significantly higher than short-term ones. Conventional economic wisdom says that signals a robust recovery, because it reflects the conditions for a rebound: growth, inflation, and higher rates in the future.
Yet few economists are changing their forecasts for a sluggish recovery. Bond prices, they say, are being determined by factors other than fundamentals.
Even though the yield curve is currently at “super steep levels,” portfolio manager Darcy Briggs, like many investors and economists, said he is skeptical the U.S. economy is poised for a rapid recovery. The unemployment rate remains high, banks are still rebuilding and there's a risk that policy makers err as they attempt to unwind stimulus.
“The odds are that the yield curve is pointing to growth,” said Mr. Briggs, who manages assets worth about $4-billion at Bissett Investment Management.
“The amount of growth is subject to debate.”
The gap, or “spread,” between two-year and 10-year U.S. Treasury notes reached a record for a second consecutive day Tuesday, widening to as much as 288 basis points.
Before this week, the previous record was 281 basis points, or 2.81 percentage points, reached on June 5, when demand for Treasuries plunged after an employment report suggested the labour market was stronger than many economists had expected, according to Bloomberg News.
Bond yields rise when prices fall and drop when prices climb.
The current yield curve is suggesting the U.S. economy will expand 4 per cent next year, a rate that is almost double the pace of growth in the third quarter and far in excess of most predictions for 2010, said Mark Chandler, a fixed-income strategist at RBC Capital Markets in Toronto.
But the yield curve is a cloudy crystal ball because this recession is atypical in that it resulted from a collapse of financial markets and lending, rather than a sudden drop in consumer demand.
Instead of simply using lower rates to lend, financial institutions are instead rebuilding reserves that evaporated during the crisis.
The result is typically reliable market indicators are sending mixed messages.
The higher yields on 10-year notes and 30-year bonds at the “long end” of the curve reflect expectations for the higher inflation that goes hand-in-hand with a booming economy.
Yet there's reason to be skeptical that inflation expectations are driving longer-term yields higher because it will take so long to rebuild the wealth destroyed by the financial crisis.
More likely, supply of government debt is momentarily exceeding demand as investors close shop until after the Christmas holidays, suggesting the curve will flatten before too long, Mr. Chandler said.
“The difference this time around is the credit channel is broken,” Mr. Chandler said.
“That means the information from the yield curve is broken.”
A steep yield curve is also good for banks, which tend to fund their operations by borrowing over shorter terms, while their lending tends to be over longer periods at rates dictated by the prevailing yields on government debt.
Low rates at what economists call the “short end” of the yield curve signal businesses and consumers can borrow relatively cheaply, an irresistible incentive to spark economic activity.
Usually, most of the yield-curve spread is explained by changes at the short-end, where yields on 2-year notes and bills of shorter duration trade in lock-step with central banks' benchmark lending rates.
But with the U.S. Federal Reserve pledging to leave its federal funds rate at a level close to zero for a period that most investors say will last well into next year, the yield curve is being dictated by changes at the longer end of the curve.
The yield on the U.S. 10-year note rose to 3.75 per cent Tuesday, the highest since the summer, according to BMO Nesbitt Burns.
