The bond market is still anticipating an economic downturn, reports today's Wall Street Journal. Although the Fed has hiked short term interest rates eight times in the past year, long term yields have continued to fall.
The spread between the two year Treasury note at 3.7% and the ten year Treasury bond at 4.3% is now a little more than a half-percentage point, a quarter-point below its historical norm. When the spread has narrowed like this in the past, it has signalled an economic slowdown, as indebted consumers struggle to meet their interest payments in a low inflation environment.
According to the Journal, there is at least $2 trillion of vulnerable floating-rate consumer debt tied to credit cards, mortgages, and other loans, with some estimates ranging as high as $4 trillion, or nearly a third of all consumer debt outstanding. Narrow spreads also curtail the supply of bank credit to corporations.
Some economists surveyed by the Journal, though, say that the yield curve is no longer a reliable indicator. They argue that bank lending has effectively been displaced by corporate bonds and mortgage backed securities in the credit market, and that low rates at the long end in these asset classes will continue to support consumer and business spending. The unexpected higher rate of job growth reported last week has also been cited as evidence that the direction suggested by the yield curve is misleading.
MG ----------------------------- Yield Curve May Be Sending a Signal
Yield Sign: Shrinking Disparity Between Long and Short Notes Waves Caution Flag on Economy By MARK WHITEHOUSE Staff Reporter of THE WALL STREET JOURNAL May 9, 2005; Page C1
Like animals before a storm, the bond market has been exhibiting ominous behavior: The difference between short-term and long-term interest rates -- known as the yield curve -- has been shrinking, a trend that in the past preceded economic downturns.
The phenomenon, say some economists, suggests that investors believe the Federal Reserve's interest-rate increases, intended to curb inflation, have squelched economic growth. "The Fed has gone too far," says David Rosenberg, chief U.S. economist at Merrill Lynch in New York.
Others say not to worry. "I see it more as good news than bad news," says Frederic Mishkin, a finance professor at Columbia Business School in New York and former director of research at the Federal Reserve Bank of New York. "We're in a situation where inflation expectations seem to be tied down, and that's really good for the economy."
The Fed has raised short-term interest rates eight times during the past year, pushing the yield on the two-year Treasury note from 2.376% to 3.724% Friday. For the same period, the yield on the 10-year Treasury has fallen from 4.604% to Friday's 4.264%.
Thus, the difference between two-year and 10-year Treasury yields -- what traders call the spread -- has fallen from 2.228 percentage points to 0.54 percentage point, well below the historical average of about 0.75 percentage point.
(On Friday, prices of Treasurys finished sharply lower, pushing up yields, after a better-than-expected payrolls report; the 10-year note fell 26/32, or $8.13 per $1,000 invested. The 30-year Treasury fell 24/32 to yield 4.631%.)
It is unusual to see long-term rates fall when short-term rates are rising. One explanation gaining popularity is that bond investors believe, Friday's payrolls report aside, that the economy will slow and force the Fed to reverse its rate increases. Those investors are willing to buy 10-year Treasury notes that pay a yield of only 4.26% because they expect short-term rates to be lower in the future, the thinking goes.
Doomsayers who buy into this needn't look far for evidence of economic stress. Troubles at General Motors Corp. and Ford Motor Co., both of which have faced credit downgrades amid plummeting North American sales, could suggest that the global economy's primary engine, the U.S. consumer, is running out of steam.
"We're starting to see cracks in certain sectors, which suggests to me that consumer spending is very susceptible to higher interest rates and high energy prices," says Mark Kiesel, an investment-grade portfolio manager at Pimco, an asset-management firm based in Newport Beach, Calif.
U.S. consumers feel Fed rate increases more than ever because they have taken out a lot of floating-rate loans, in the form of credit-card debt, adjustable-rate mortgages and home-equity loans. Most estimates of total floating-rate consumer debt hover around $2 trillion, or 20% of all consumer debt. This means that each one-percentage-point jump in short-term interest rates, if sustained for a year, should cut total consumer spending by about 0.6%, says Mr. Rosenberg of Merrill Lynch. But that could be an underestimate: Using lien data from county courthouses across the U.S., Stuart Feldstein, president of SMR Research Corp. in New Jersey, calculates that about 32% of all mortgage loans are floating-rate, which would suggest floating-rate debt stands at over $4 trillion.
As rates rise, some people with a lot of floating-rate debt probably won't be able to make their payments, creating problems for banks and finance companies. A flattening yield curve, in the trader's lingo, also directly lowers profits for banks, which usually borrow money at short-term interest rates -- in the form of deposits -- and lend at long-term rates. Troubled banks make fewer loans, which leads to slower economic growth.
"If the banking industry has a problem, then that's going to affect the availability of credit for commercial uses as well as for the consumer, and that's not a good thing," Mr. Feldstein says.
Banks, however, don't play as big a role in the economy as they once did. During the past few decades, the growth of the markets for corporate and mortgage bonds has provided people and companies with other ways to borrow money. As a result, say some economists, low long-term interest rates are just as likely to stimulate as to stunt growth.
"There's no genuine effect of a flat yield curve," says Jan Hatzius, senior U.S. economist at Goldman Sachs in New York. "All the flat yield curve does these days is say that Mr. Market thinks economic activity is going to be weak."
Lately, Mr. Market hasn't been a very good forecaster, says Joseph LaVorgna, chief U.S. fixed-income economist at Deutsche Bank in New York. Back in the mid-1970s, he says, the yield curve and economy moved up and down together, with the curve leading the economy by about a year. But by 2001 that correlation had broken down.
