The Inverted Yield Curve Update - 7/5/06

On 2/1/06 and then again on 3/3/06 we wrote about the concerns the Inverted Yield Curve held for the economy and the markets.  Today we update our perspective on the inverted yield curve and what it means now.

First, a brief review of the yield curve.  The yield curve is a plot of the yield on bonds with the same credit quality across different maturities (the link above provides an interesting interactive model of the "living" yield curve).  The basic assumption is you get more interest on your investment in a bond by holding it longer.  The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days.  Bloomberg provides an current chart of the yield curve for U.S. Treasuries at  Bloomberg.  The chart below is from the Bloomberg site as of the end of business February 1, 2006.

The green line is for the current day and the orange line is the day before.

Now compare the above yield curve to the chart below as of end of business March 3, 2006.

A couple of things to note when looking at these two charts are:

• The 10 year rate is still above the 90 day T-bill rate.  The 10 year rate was below the 90 day T-Bill rate for a while in February.  Remember, these were the key rates in a study by Professor Campbell Harvey on the ability of the inverted yield curve to predict recessions.
• The middle of the yield curve has moved up dramatically and the 10 year bond rate has risen approximately 40 basis points so far in 2006.
• 10 year rates were experiencing a substantial rate increase in a very short period of time.

Now let's move forward to July 5, 2006, a couple of days after the FOMC raised the target rate to 5.25%.

Looking at the latest yield curve note:

• All rates are higher than they were in March.

• The 10 year rate is above the 90 day T-bill rate.  Remember, these were the key rates in a study by Professor Campbell Harvey on the ability of the inverted yield curve to predict recessions.

• The yield curve is relatively flat, indicating that presently the market does not believe that we are nearing the end of the current interest rate hikes by the FOMC.

So what do we do now? Before I answer this question, let's examine that the Fed said in their press release on June 29, 2006, announcing the most recent interest rate increase.

Typically, there are six paragraphs in each statement. The first and last tow rarely change, other than to announce the change in rates. The 2nd, 3rd and 4th are the important paragraphs to investors and traders. Let's look at what they said and what it means to us. I have highlighted the phrases that I believe are the most important.

"Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.

Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives."

Most observers indicated that the Fed's statement hinted that inflation was well under control and that further rate hikes would not be necessary. I believe this thought comes from the first three highlighted phrases in paragraphs 1 and  2 above. However, reading the next 3 phrases indicates that inflation pressures remain and that further rates hikes are certainly possible. The most important sentence for me is a new one for this release: "However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures."

Since the Fed has almost always raised rates further and longer than most people expect, I believe that we will see more rate increases in the future. Between now and the next Fed meeting on august 8th, we will get two key indicators of inflation. One in June 15th when the the inflation numbers for June come out. A little later we will get the second quarter Gross Domestic Product (GDP) number. On June 30th the first quarter revision GDP number came out at a revised 5.6%. That is rapid growth and not an indicator of a slowing economy. This leads me to believe that the GDP for the second quarter will be greater than 3% leaving room for the Fed to raise rates again in August.

There will be two more inflation numbers before the September meeting. If the economy is slowing down and inflation is coming down, both of which are possible, then the Fed may indeed pause. However, a slowing economy is not going to be good for profits, and thus not good for the stock market. But if the economy continues to expand rapidly, then the Fed is going to continue to raise rates, as they fear inflation will raise its ugly head. Some economists claim that the Fed rate will be at 6% by the end of the year. If you are bullish on the economy, then that is a perfectly rational expectation.

But if rates continue to increase, then that is ultimately not going to be good for mortgage rates and the housing market. That will also impact consumer spending. That outcome is not good for the stock market either.

So again what do we do now? Well, we must continue to watch the yield curve looking for signs that the market believes that the rise in interest rates is coming to an end. Also, we need monitor the curve to see if 90 day T-bill rates exceeds the 10 year rate.

We also need to be careful in our stock selection and place our stops to protect our hard earned capital. During these times it is imperative to select quality companies that are temporarily experiencing lower stock prices, using our stock watch list in our Premium Portfolios. When these opportunities present themselves I will update our website and send emails to all Premium Members. When warranted I will also enter trades for the the Starting Out Portfolio as well.