Kamp's Comments - What the Inverted Yield Curve Might Be Telling Us - and What It Could Mean to Fixed Income Investments

by Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF

As you may know, the Treasury yield curve is currently inverted, negatively sloped, meaning that bond yields at long maturities (10 years or above — those typically used in long-term bond funds) are lower than those at short maturities (three months to two years — those typically found in money market and short-term bond funds).  In the following dialogue, we will examine:

• The rarity of inverted Treasury yield curves and when they typically occur
• Some explanations of why yield curves become inverted
• What the messages coming from the current inversion could mean to fixed income investments going forward

Usually, the Treasury yield is not inverted (it is typically positively sloped, with long-maturity yields higher than short maturities). There are good reasons for this, including the fact that higher yields, which mean lower bond prices, are required to induce people to invest their money for a longer time, which inherently has more uncertainty.

All else being equal, the prices of longer maturity bonds have a greater sensitivity to market interest rate movements than their short-maturity counterparts, meaning that long-maturity bonds typically show greater volatility from interest rate movements.  Hence, investors typically demand a higher yield on long-maturity bonds as compensation for the increased uncertainty and risk that come with investing at longer maturities.  Only if other forces ? usually strong expectations that market interest rates will be falling in the future ? more than offset this typical, positive slope does the Treasury yield invert.

But such occasions are quite rare.  Since the advent of the "new" monetary policy era in late 1979, the Treasury yield has been inverted (i.e., 10-year yield versus three-month yield) just 8% of the time (using monthly averages) and for only three periods lasting (excluding the current period) seven months on average.  The current period of inversion only began in August and thus far has lasted a below-average five months. Typically, inversions have occurred after a period when the Federal Reserve (Fed), in its role as an inflation fighter, has been raising short-term interest rates aggressively, forcing the short end of the yield curve to rise much faster than the long end. 

In fact, many inversions occur after the Fed has been tightening for quite a while and to such an extent that bond investors may have concluded that the economy will soon slow significantly (perhaps even fall into recession), causing inflation to decline and setting the stage for the Fed to lower short-term interest rates. Indeed, it is precisely such investor expectations that typically cause longer-term bond yields to fall towards the end of a Fed tightening cycle.  Anticipating this scenario, bond market investors redeploy their funds to longer maturities, thereby lowering long-term bond yields (by bidding up bond prices) and raising yields at shorter maturities.

Currently, the deployment of funds to the long end of the yield curve and the resulting lower long-term bond yields have occurred in an environment where longer-term yields have been low for quite some time, not only in the United States, but also in many developed economies (except the U.K.). This is probably the result of the lower global economic and financial volatility of recent years and the massive investment (recycling) in developed markets of funds that foreign nations (notably China and Japan) have accumulated by running large trade surpluses with developed economies (especially the U.S.) for years. As a result, the long-term government bond yields of Germany and even of Greece are lower than the low yields in the U.S.

What is the current yield curve likely telling us about bond investor expectations?  Although a number of rationales can be offered to justify the curve's currently inverted status, I prefer the typical one outlined above: bond investors now think that the economy will remain in a "soft patch" for a while (perhaps for another six months or so), that there is a higher probability of recession next year, that the elevated inflation of late will subside, and that the Fed will probably cut interest rates in 2007.  If indeed this is what bond investors are expecting, these forecasted developments, if they were to materialize, have some interesting implications for bond investors.

First, bond investors may consider moving more money towards long maturities, if their convictions are strong that market interest rates will be moving lower in the future.  By doing so, they would be configuring their portfolios to potentially pick up the additional return (a capital gain) that would come from the higher bond prices that would result from lower market interest rates.  Second, where such convictions are weak, bond investors could focus their investments at the shorter end of the yield spectrum to pick up the higher current yield at the shorter end of the curve. This is especially true if investors think short-term market rates could rise further (i.e., that the current expectations embedded in yields at the long end of the curve are wrong).  Such investors would glean additional returns (and avoid the capital loses of longer maturity investment) by sitting at the short end as short-term rates rise.  In addition, whether or not investors should gravitate towards quality issues (those with high credit ratings) again depends critically upon one's strength of conviction regarding the course of the economy and interest rates over the coming year.

In summary, the current inverted yield curve is a rare event historically and is most likely reflecting investors' expectations that the softer economy of late will continue, that inflation will subside, and that the Fed will be lowering rates next year.  But, how an investor should position a fixed income portfolio depends on how strongly the investor buys into the message coming from the current yield curve.

Leo also is available to comment on economic data. If you wish to speak with him please notify Chad Peterson at 1 212-916-4808.

Kamp's Comment is prepared by TIAA-CREF Asset Management and represents the views of TIAA-CREF's Investment Strategy and Client Solutions Group as of October 10, 2006. These views may change in response to changing economic and market conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Data is as of 6/30/06 unless noted otherwise.

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