By Tom Buerkle
NEW YORK (Reuters Breakingviews) - The bond market may be throwing investors a curve ball. The difference between two-year and 10-year U.S. Treasury rates is the smallest since before the financial crisis. The possibility of an inversion, when long-term yields fall below short-term rates, has raised recession fears. Yet it’s a flawed indicator.
Bond buyers typically want rates to cover expected inflation and provide a premium for locking up their money. The longer the maturity, the longer the lockup – and the higher the all-in yield needs to be, in theory. The so-called yield curve, plotting rates against maturity, usually slopes upward.
Lately, though, the curve has been almost as flat as a pancake. The Federal Reserve has boosted short-term policy rates by 1.5 percentage points since December 2015, but longer-dated yields have edged up only grudgingly. The market return on 10-year Treasuries was only 0.41 percentage point higher than the two-year rate at one point last week.
If that shrinks further or goes negative, it could signal weakness in the economic outlook. Inversions typically precede recessions. But the alert can come so early as to be almost useless. The curve inverted in June 1998, for example, nearly three years before recession hit. An investor who reacted by getting out of stocks would have missed a 36 percent gain before the market peaked.
There are reasons for today’s yields. Inflation remains ultra-low given, for instance, the relatively tight labor market. Some investors concerned about lofty equity valuations have shifted some funds into bonds, as the $357 billion California Public Employees’ Retirement System did earlier this year. Foreign investors have increased their holdings of U.S. government paper by roughly $275 billion over the past year, according to Treasury data.
Those forces aren’t permanent though. A weakening dollar could reduce foreign appetite. The Fed is gradually reducing its holdings of Treasuries. And worries are growing about the deficit, which the Congressional Budget Office projects will exceed $1 trillion a year by 2020. That may explain why, despite the flat yield curve, 10-year rates are rising towards 3 percent for the first time in more than four years.
Another recession will come, at some point. But for now there are more real and immediate dangers for investors to worry about.
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