OT: Danger Signals in the Bond Market from Smart Money

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-- Susie (Susie0884@aol.com), January 24, 2000



-- Mad Monk (madmonk@hawaiian.net), January 24, 2000.

Note the date, but still seems significant

January 21, 2000 A Danger Signal From the Bond Market? By Alec Appelbaum

SOMETHING CURIOUS is afoot today in the market for Treasury bills and bonds. It's called an inverted yield curve. Wait! Before you leave the room, you should know that inverted yield curves tend to predict economic slowdowns, if not outright recessions. Now do we have your attention?

So just what is this indicator that seems to be flashing such an ominous signal? Normally, investors demand interest rates on bonds in direct proportion to the amount of time their money is locked up in those bonds. If I have to wait 30 years to get paid back, I will demand higher rates of interest than an investor who gets paid back after a few years, largely because inflation and other factors that might affect the value of my bonds are less predictable over that longer period. This sequence of increasing rates is known as a yield curve, and it's supposed to slope upward as bond maturities grow longer. (For a quick look at how all this works, take a tour of our living yield curve.)

But now, the yield curve is out of whack. At 6.77%, the yield on a note due in 10 years is higher than the 6.72% yield on one due in 30 years. Why would long-term investors accept lower returns than investors who are locking up their money for only one-third as many years? The answer usually is that long-term investors will take less because they believe rates will get even lower in the interim  perhaps because the economy is heading into a nose dive. Or it's that shorter-term investors demand higher yields because they're nervous about the next few years. Curve inversions usually predict economic woe. Now there's one in our collective face: Should we stop tossing out all that canned corn we stocked up on for Y2K and start thinking twice about telling the boss to go take a flying leap?

Well, not necessarily. As it turns out, there are several less-dire explanations for this anomaly, and none of the strategists we interviewed seemed spooked by the 10-year inversion. David Jones, chief economist at Aubrey G. Lanston and a SmartMoney.com pundit, says a heavy supply of midterm bonds from corporations seeking to raise money is weighing on demand for bonds in that range. That added supply drives down bond prices, just as a bumper crop of oranges would drive down prices for O.J. And when bond prices go down, yields go up. Hence, your yield peak at the 10-year point.

The inversion is also confined to the 10-year bond, and that's particularly telling. Today's curve looks more like a classically flat curve than a classically inverted one, though technically it's neither. The 6.46% yield on two-year notes bonds still sits comfortably below the yield on 30-year bonds, indicating decent short- term confidence in the economy.

"If this were really a harbinger, I would expect a sharper flattening across the entire coupon curve, not just [between] 10-year bonds and 30-year bonds," says Michael Ryan, senior fixed-income strategist at PaineWebber, who also smells technical factors. Echoes bond strategist Bill Hornbarger of A.G. Edwards: "To me an inverted yield curve is not [an inversion from] 10s to 30s, it's 2s to 30s,"

In fact, suggests chief bond market strategist Tony Crescenzi of Miller, Tabak, faith in Fed Chairman Alan Greenspan could be keeping short-term yields down. As the market trusts the current Fed to remain wise and vigilant in its fight against inflation, it keeps short-term yields lower. "The important point to make is this is a technical inverted yield curve rather than a classic" one, says Jones.

You'd probably want to collect a bond strategist's salary to sit through the technical factors, but here they are if you want 'em. You've got the heavy supply of corporate bonds. You've got a Fed planning to buy back $30 billion worth of bonds of longer maturities. You've got some weakness in overseas bond markets that can affect ours. And, say the strategists we've quoted here, you might have some dealers in mortgage-backed securities selling 10-year notes to hedge against people buying fewer mortgages in the current rising-rate climate.

The salient fact: Yields for the next two years suggest impending higher interest rates, not economic washout. "We think [rates] are going to go up by 25 basis points in February," says Ryan. "The market is telling us the Fed is going to go out in March and raise rates 25 basis points and it's better-than-even odds they'll raise by 25 basis points in May." That intuition is making yield curves flatter to reflect anticipation for higher interest on bonds in the next few months. True, the gap between two-year notes and 30-year notes is pretty close to flat as investors wait for the Fed to crank up interest rates. But that anticipation is also making inflation less worrisome.

So go ahead. Look at the yield curve one more time. "People's views still seem to be pretty bullish. Our guys are saying they don't see signs of inflation," says a bond analyst at a large brokerage. At least for now, what's usually a sign of avalanche just looks like an interesting shape.

-- Susie (Susie0884@aol.com), January 24, 2000.

Great article Susie. Thanks for bringing it to our attention!

-- Duke1983 (Duke1983@aol.com), January 24, 2000.

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