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What does this economic indicator say? - Views on News from Equitymaster
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  • Dec 29, 2009

    What does this economic indicator say?

    CNN Money carried an interesting news article last week. Just the kind investors across the world were hoping for. It had a reference to the yield curve. Apparently, the curve steepened the most last Tuesday. In other words, the difference between the shorter term 2-year notes and longer-term 10-year note yields reached a record high of 2.86%.

    Now, what is it that this spread of nearly 3% signifies? Suffice to say that the last couple of times the spread was so high, the US GDP grew by nearly 3% and 4% respectively. Yield curve? Spread? Economic growth indicator? If this is sounding all Greek and Latin to you, read on.

    It is certainly well known that bonds of the same credit quality, say government bonds for e.g., are available in various maturities. Thus, there could be bond maturing in 1 yr, 5 yrs, 10 yrs, and 20 yrs. If one were to plot the line that passes through the yields of bonds with different maturity date, we get what is called as the yield curve.

    Common sense suggests that during normal times i.e., during times of trend line inflation, a yield curve would tend to slope upwards. In other words, yield for a 10-year bond would be higher than that of a 2-yr bond because of the risk involved in holding the bond for a longer period of time. Similarly, a bond with tenure of 5 years is likely to have a higher yield than the one with tenure of a year or so.

    However, just as in other realms of investing, there are times when normal rules do not apply. For example, the upward sloping curve tends to reverse direction and become a downward sloping curve. Effectively, here the bond with shorter maturity has become a higher yielding one. Thus, the 10-year bond lags the 2-yr bond in terms of yields.

    Interestingly, the US economy has worsened 5 out of 6 times since 1970 whenever an inverse yield curve has developed on the horizon. The reasons may not be difficult to find. Whenever investors sense signs of slowdown, they fear depreciation in asset values and hence, rush towards the safety of long-term government bonds. This in turn increased demand for these securities, thus pushing their yields so much down that they become lower than even the short term government bond, thus leading to an inverted yield curve.

    What was witnessed recently though was not an inverted yield curve. It was infact one of the steepest yield curves ever witnessed in recent years. This means that the yield on a 10-year government bond is significantly higher than one on the 2-year government bond. Thus, if an inverted yield curve translates into a huge demand for longer term treasuries, a steep yield curve means falling demand for the same.

    Such a situation can arise when investors sense economic recovery and feel that with the recovery will come inflation and hence bonds, that have limited upside potential, are not the place to be in and other asset classes like equities and commodities offer better odds of greater returns.

    That is indeed likely to be the case this time around. The US Fed has really turned on its printing presses like there is no tomorrow. It is flooding the system with dollars. While this may not be showing in the US GDP numbers just yet, it is definitely propping up prices of a lot of assets, thus forcing investors to abandon the safety of government bonds and chase better returns.

    Considering that the US government is likely to keep its policy of cheap money intact, don't be surprised if the yield curve steepens further. Also, while it might correctly predict the expansion in US GDP this time around as well, it does not do a very good job of highlighting its structural weakness. Thus, it could well be followed in short order by an inverted yield curve!



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