Is the Treasury Yield Curve Sending
Out a Troublesome Message?

Mike Larson | Friday, December 4, 2015 at 7:30 am

Okay, I’ll admit it. I’m a yield-curve junkie. It’s not like ‘fessing up will keep me from sitting at the “cool kid” table since my high school days are long gone, so I figure I can share that with you.
Now I’ll admit something else: I’m a bit worried about the troublesome message the curve is sending out. To understand why, let me start with the yield curve basics.
First, the government issues Treasury bills, notes and bonds with a wide range of maturities — from as little as one month all the way out to 10 and 30 years.
If you plot the yields on each of those Treasuries on a piece of graph paper, then draw a line connecting them, you get a picture of the current Treasury yield curve.
Second, the yield curve is a living, breathing indicator. After all, as investors buy and sell Treasuries, the yields on those Treasuries constantly fluctuate. That causes the shape of the yield curve to change as well.
Third and most importantly, the shape of the curve can tell you important things about monetary policy, the economy, inflation fears and market expectations about the future.
When investors are confident about the future growth outlook, and fearful of inflation, they buy shorter-term Treasuries and sell longer-term ones. This causes short-term yields to remain relatively low, even as longer-term yields rise.
That, in turn, gives you a “steep” yield curve — one that slopes up and to the right. That’s because the plot points for 10-year and 30-year Treasuries are much higher than the plot points for 1-year or 2-year Treasuries.
When Federal Reserve policymakers start talking about raising short-term interest rates, or actually raise them, the process begins to change. Investors start selling short-term Treasuries to avoid losses stemming from the central bank hikes. Then they do one of two things:
1) If they fear the central bank is “behind the curve” and not raising rates aggressively enough to stamp out future inflation, they sell long-term Treasuries, too. That means the yield curve stays steep because all rates rise at essentially the same pace.

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2) If they worry that the central bank hikes are too aggressive and that the economy can’t handle the pressure, they start buying long-term Treasuries. The bet they’re making? The Fed hikes will crush future growth and inflation, or even drive the economy into recession. This causes the yield curve to flatten, because long-term yields fall even as short-term yields rise.
That brings me to present day. Investors aren’t aggressively selling longer-term Treasuries. They’re holding on to them, even as they’re selling at the front end of the curve. That’s causing the curve and key rate spreads to compress.
Take a look at this chart, which shows the difference (or spread) between the yield on the 2-year Treasury and 10-year Treasury …

Click image for larger view

You can see this key spread has fallen sharply in recent weeks, and just shrank to 124 basis points (1.24 percentage points). That’s very close to the smallest in seven years.
The clear implication? Investors are worried that the economy and credit markets remain fundamentally, intrinsically weak. They’re looking at many of the same indicators I am — junk bonds, leveraged loans, bank lending standards, etc. — and deciding that all is not well behind the scenes.
We don’t have an inverted yield curve yet — where short-term rates are actually higher than long-term ones. But it’s the trend in the curve that concerns me, and if the pace of flattening intensifies, my level of concern will rise.

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The prudent course of action seems pretty clear to me: Continue to maintain elevated levels of cash. Invest only in stocks that offer yield protection, high ratings, and/or that operate in less economically sensitive sectors.
Then look to generate profits from investments targeting vulnerable stocks with downside risk. That would include financials that will get whacked by a flatter curve and deteriorating credit market conditions. You can get more details about specific names, and buy and sell targets, in my Interest Rate Speculator service.
Until next time,
Mike Larson
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Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.

The investment strategy and opinions expressed in this article are those of the author and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.