Yield Curve Often Used As ‘Economic Indicator’

BERLIN – For a clue about where the economy may be headed, the yield curve is often the place to look.

“It’s a leading indicator,” says David Rosenberg, Chief North American Economist for Merrill Lynch. “Comparing the current market yields of short- and long-term bonds frequently reveals what investors expect the future to bring.”

Yet the spread between the 3-month London Interbank Offered Rate (LIBOR) and 10-year Treasury is still very inverted, and this is important because the three-month LIBOR is a key lending rate for consumers and corporations.

A basic yield curve plots the yields and maturities of different bonds on a graph. The horizontal axis represents years to maturity, and the vertical axis represents yield. In the normal scheme of things, longer-term bonds pay a higher rate of interest than their shorter-term counterparts, to reward investors for the greater risk of tying up their money for a longer period. So the typical shape of a yield curve is a slope that rises gently upward from left to right.

But during different points in the economic cycle, a yield curve may take on different shapes, usually to reflect a shift in investor expectations. For example, beginning in June 2006, the yield curve for Treasuries became inverted — that is, it showed higher yields for two-year Treasuries than for 10-year bonds. That change, Rosenberg says, may have anticipated today’s soft economy. Investors anticipated what has now come to pass, with slowing growth pushing the Federal Reserve into rate-cutting mode. More than a year ago, sensing lower rates on the horizon, investors preferred shorter-term bonds.

“The yield curve can tell you more about what will happen in 12 or 18 months than it will the present,” says Rosenberg, who notes that each of the eight recessions since 1950 was preceded by a flat or inverted yield curve.

Today, in a market riled by the subprime mortgage crisis and uncertainty about the direction of interest rates, different yield curves present conflicting views of what’s to come. While the Treasury curve now shows a more typical slope, seeming to suggest that economic conditions may be on the mend, a deeply inverted LIBOR curve may signal continuing concerns about recession. “In fact, the Treasury yield curve is steepening for the wrong reasons – not because there’s good news about the growth outlook, but because banks have been holding more cash during this period of weakening credit quality,” Rosenberg says. “Meanwhile, the corporate yield curve does not reflect the idea that we’re heading toward economic expansion.”

Traditionally, the transition from an inverted yield curve to a positively sloped curve comes only after the Federal Reserve tightens monetary policy, and that’s something Rosenberg doesn’t expect to see soon. “The Fed won’t be done cutting interest rates until there are clear signs that the credit turbulence is behind us or that the housing recession has ended,” he says. In the meantime, though the Treasury yield curve will steepen further, Rosenberg thinks that signals an economic recovery more likely to come in 2009 than in 2008.

So how do changes in the yield curve affect your portfolio? Talk to your financial advisor regularly about the maturities of your fixed income holdings and whether signals from the yield curve mean that it’s time to make adjustments in your investment strategy.

(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-9084.)