THE SHAPE OF THINGS TO COME / BARRON´S MAGAZINE ( A MUST READ )

Up and Down Wall Street

WEDNESDAY, JULY 21, 2010

The Shape of Things to Come

By RANDALL W. FORSYTH

The still-steep yield curve looks likely to flatten further, which will make income even more valuable.

IN The Graduate, some middle-aged codger imparted his wisdom to Dustin Hoffman's character, young Benjamin, in just one famous word, "Plastics."

What this middle-aged codger would utter today would be encapsulated in two words, "Yield Curve." (Meanwhile, I continue to lust after the true object of desire from the film, Benjamin's Alfa-Romeo Duetto.)

No doubt, the mention of "Yield Curve" is as powerful conversation-stopper as "Plastics" was in just about any social situation. But as a forecaster of interest rates and the future course of the economy, the yield curve is one of the best around.

Only this time really is different. (I shudder just to type those words.)

To digress, the yield curve is a graph of interest rates starting from the shortest maturities to the longest, a range from just 30 days or less out to 30 years, usually for Treasury securities in order to filter out credit risks. In normal times (whatever those are) the yield curve would be rising gently from left to right, or a slope that is positive in mathematical terms. That would be to compensate investors or lenders for the trouble of tying up their money for lengthy periods.

If they expected interest rates to rise in coming months or years, they would demand a bigger premium to commit to longer-term maturities. Why would they expect that? A strong economy that could generate robust demands for credit or inflation. That's the traditional inference drawn from a positive yield curve.

Conversely, sometimes the yield curve turns negatively sloped or "inverted." This historically has been a portent of lower interest rates. Investors accept lower yields on longer maturities because they anticipate a break in interest rates, which would be the result of an economic downturn or falling prices, or both.

That configuration hasn't been seen in recent years. But in 2006 and most of 2007, the Treasury yield curve was almost perfectly flat at around 5.25% amid calls for the Federal Reserve to raise its federal-funds target. This column argued that the flat yield curve indicated that the next move in interest rates was lower. Then came the beginnings of the credit crisis in August 2007, setting off the tumble in interest rate to historic lows.

So, what is one to make of the current sharply upward sloping yield curve? By this standard theory, the curve is pointing to significant and long-running rises in bond yields. Investors are demanding a significant premium to compensate for the risk of extending maturities.

Or, viewed another way, they are willing to forego significant current income by sticking with short maturities in order to avoid the capital losses that would result from rising bond yields. That would make sense given the drumbeat of bond bears who see an inevitable surge in interest rates from inflation generated by the Fed's low-rate policy and trillion-dollar federal budget deficits as far as the eye can see.

Yet a few dissenters say what's different this time is that the Fed has fixed short-term rates near zero, reducing the scope of the of the yield curve's possible fluctuation. And as the prospect of an eventual Fed rate hike is pushed further out in the future, the likelihood is for the yield curve's upward slant to flatten.

That's the view of Markus Krygier, deputy chief investment officer of Amundi London, part of Amundi which ranks among the top ten global payers in asset management with around €688 billion under management. He sees bets on a further flattening of the U.S. Treasury yield curve as an almost certain winner—regardless of which way interest rates move.

To be sure, the yield curve has flattened in the past three months. Since the beginning of April, when the consensus was that interest rates had nowhere to go but up, the benchmark 10-year Treasury yield has fallen from 4% to just under 3%, to 2.95%.

At the same time, the two-year note yield has tumbled to 0.58%, close to a record low, from a peak of 1.17% in early April. The spread between the two- and 10-year notes thus narrowed to 237 basis points (2.37 percentage points) from 283 basis points at the curve's steepest slope.

The flattening has come against a near-continuous parade of economic indicators showing slowing growth and no inflation, which has delayed the likely date of an eventual Fed rate hike well into 2011. That's also been responsible for the marked drop in the dollar over that span, Krygier adds.

Should expectations of higher interest rates reappear, he expects it to result in a sharper rise in yields on the short end than the long end of the curve—a "bear flattening" in bond parlance. But if, as seems more likely, this "man-made" recovery resulting from stimulus and inventory restocking fades further, the interest-rate premium on the long end should diminish, resulting in a further "bull flattening."

Indeed, were it not that the Fed has anchored the short end of the yield curve at virtually zero, it might be sending a rather different signal about the economy and interest rates. Obviously, the yield curve can't invert and send a recession warning signal with the fed funds rate at just 0-0.25%, observe Goldman Sachs' economists. Omitting the yield curve from their forecasting model gives a 25% probability of a recession in the next six months.

Meanwhile, the prospects for deflation now are greater than inflation, according to one of the market's true thinkers, GMO's Jeremy Grantham, who previously had declared himself agnostic about the odds for inflation versus deflation.

"I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout," Grantham writes in his quarterly letter. "But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future."

That points to a continued bull flattening, which in plain English means already paltry bond yields could dwindle further. That puts anything that generates income—not just bonds but also preferred stocks and common shares with solid and growing dividends—at a premium.

All of which could make prospects of a flatter yield curve actually interesting.

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