The bond markets sent out a warning signal for the U.S. economy Tuesday, after a closely watched market indicator with an uncanny record of forecasting recessions popped up on trading screens.
In an otherwise uneventful day in fixed income markets, with most traders off for the holidays, the yield on the two-year U.S. government bond note edged up and passed the yield on the 10-year bond. It was the first time the yield curve — the shape of a plot of yields, left to right, on short-term treasury bills all the way out to long-term bonds — had “inverted” in five years.
For the optimists, it's a sign that inflation is under control and the rate-setting arm of the Federal Reserve Board has done its job and should stop pushing rates higher. That's the soft-landing crowd. More ominously, others know the indicator has a nasty habit of foreshadowing an economic slowdown or recession and a terrible stock market.
“Here is the historical record — we have endured eight Fed tightening cycles in the past three decades: the Fed has inverted the curve on five of those occasions, and out of those five Fed-induced inversions, the economy slipped into recession a year later all five times,” said David Rosenberg, North American economist for Merrill Lynch & Co. Inc.
In early trading Tuesday morning in Europe, the yield on 10-year Treasuries dipped below the two-year yield.
The yield on 10-year Treasuries briefly traded below 4.38 per cent at one stage, while the two-year note hit a high of 4.41 per cent, according to Reuters. In North America, the yield on 10-year bonds remained above the two-year yield for most of the day, but ended the day inverted with the two-year note yielding 4.34 per cent and the 10-year 4.33 per cent.
Investors are prepared to accept a lower rate of return on the riskier long-term bonds than short-term notes because they fear the economy will slow down dramatically. At that point, the rate-setting arm of the U.S. Federal Reserve Board would stop raising rates (end it's tightening cycle) and instead begin to lower short-term rates.
The Fed has raised the federal funds rate 13 times since June, 2004, by one-quarter of a percentage point to 4.25 per cent. Bond markets are currently anticipating at least one more rate hike and possibly two, which would suggest a yield inversion could last several months.
Investors should take notice. The last time the yield curve inverted was in early 2000, which signalled the bursting of the technology stock bubble.
But many economists and investment strategists think this time will be different and the Fed will be able to orchestrate a soft landing. Monetary policy is not tight and the inversion is a result of unusually low long-term rates, they say.
The end of the rate tightening cycle would be good news for the financial markets, such as bank stocks because investors could begin anticipating lower interest rates as the economy cools.
Based on history, the low level of long-term bond yields relative to the price-earnings multiples also suggests the S&P 500 is about 20 per cent to 25 per cent undervalued, according to a report by Citigroup Inc. Citigroup forecasts the S&P 500 will increase about 11 per cent to 1,400 in 2006 from yesterday's close of 1,256.54.
“[The inverted yield] has been taken as a negative omen, but I think you have to be cautious in today's circumstances,” said Andrew Busch, global foreign exchange strategist for BMO Nesbitt Burns Inc. The yield has inverted at relatively low levels of interest rates and not the normally high levels of rates when the Fed tightens to subdue inflation, he said.
All indications are that inflation in the United States remains relatively muted despite the high prices for oil, gas and other commodities.
However, one sector of the economy that is likely to slow down is consumer spending, Mr. Busch said. Consumer spending in the U.S. during the past couple of years was 0.5 per cent to 1 per cent more than it would normally have been as a result of homeowners taking out home-equity loans but the borrowing costs on those loans are now prohibitive, Mr. Busch said.
During the past 20 years, 10-year yields have exceeded two-year yields by an average of almost one percentage point, according to Bloomberg.
“This clearly suggests we are very close to the end of the tightening cycle ... and it is not an indication of a recession,” said Michael Rottman, a strategist at Germany's Hypovereinsbank.
