Money Matters: See the future in the power of the yield curve

By Cody B. Bartlett Jr.
The Daily Record Newswire

You can listen to the world’s most respected economists. You can read the most insightful finance books. You can have a conversation with Sir Alan Greenspan, but none of these sources will provide you with a more accurate picture of the future of our economy than will the term structure of interest rates.

The graphic form of the term structure of interest rates is referred to as the yield curve. The yield curve simply graphs U.S. Treasuries of varying maturities (ranging from 3 months to 30 years) on the X-axis with the corresponding interest rate on the Y-axis. This simple graph is the single most accurate predictor of economic and stock market performance available to investors. In effect, the collective actions of bond traders allow us to see the future of the economy.

The yield curve exhibits four common shapes that signal what is in store for the future of the economy:  normal, steep, inverted, and flat or humped. Under normal economic conditions bond investors will demand a premium for tying up their money for a longer period of time, hence a normal yield curve will rise gradually as the maturity of the bond increases.

A steep yield curve is generally experienced prior to a period of large economic expansion. The curve is steeper than normal anytime that the yield on the 30-year Treasury exceeds the yield on a 3-month bill by more than three percentage points. Long-term investors will demand a higher premium for tying up their money if they believe that they could make more money investing elsewhere. In early 1992, just prior to the beginning of the most recent bull market, the yield on the 30-year Treasury exceeded the 3-month yield by five percentage points. What followed was the longest bull market in our nation’s history.

An inverted curve is extremely rare but is almost a sure bet that the economy is about to slide into a recession. It is counterintuitive that investors would require a smaller premium to invest their money for a longer period of time yet this has happened several times in the past.

Basically, the collective investor believes that economic outlook is grim and that interest rates will plummet in the future so they are willing to accept less premium in order to lock in at a rate before interest rates collapse.

We experienced this unusual economic state in July 2000 and in the middle of 2007. Many economists balked at the predictive power of the curve and said the inversion was due to supply problems with the long Treasury. As you are probably painfully aware, the curve was telling investors to reduce their stock exposure as a recession was on the horizon.  Once again the power of the yield curve prevailed.

Finally, a flat or humped yield curve occurs when short-term and long-term rates are the same. When this occurs the middle or belly of the curve will usually have a slight hump to it.

This shape does not have the clear cut predictive power of the other shapes, as the curve could go inverted or return to a normal shape. In general, it indicates that the economy is about to hit a snag and will either pull out of it or slide into recession.  

So what is today’s yield curve telling us? Below is a table of the current term structure of interest rates:
Maturity              1/24/11
3 Month             0.15%
6 Month             0.18%
2 Year                0.62%
5 Year               2.00%
10 Year              3.40%
30 Year              4.56%

The current shape of the yield curve is almost as steep as has been at any time in U.S. history. The curve is telling us that the economy should experience above average growth in the future, which is a positive for stocks, but be careful bond investors for it is also signaling future inflation concerns.

Cody B. Bartlett Jr. is managing director of investments/investment strategist at Karpus Investment Management in Pittsford, N.Y. He can be reached at phone (585) 586-4680.