Flat Yield Curve!

Mark Thoma asks: When should we worry about the yield curve?



Chart courtesy of Angry Bear

Note that each inversion (spread < 0) preceded a recession.

Here’s how falt we are:

FED Funds Rate: 4.5% (overnight)
6 Month CD 4.37%
Five Year Note: 4.54%
Ten Year Note: 4.54%
30 Year Bond: 4.53%

Let me remind you that last year, the S&P500 gained about 4% — about what you would get from a CD, but with quite a bit more risk.

That factoid is another element why if the market starts to fade, more than a few equity holders will see it as an unpleasant repeat of 2005.

I can imagine that during any "unpleasantness," the so-called weak hands will dominate not only  the selling, but the lack of buying interest, too.

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What's been said:

Discussions found on the web:
  1. B commented on Feb 24

    It’s interesting that State Street’s professional money manager survey is showing the most bearish reading since it started 8 years ago at the same time the retail investor is piling in. And, they are piling in the the highest risk markets, international. The pro’s record isn’t one of greatness since they were also suckered into being bullish at the top in 2000 but it’s better than the retail investor.

    So, with negative volume since the end of December being higher than it was from the decline into October, while we are sitting at a peak in the indices, what does that mean? Can you say DISTRIBUTION? So, if the pro’s are leery, who’s going to bid up stock prices? Retail investors? I am a big fan of risk adjusted returns. I’m quite happy with 4+% which will soon be 5%.

    Still think the long bond rates are going higher. It’s only a matter of when. IMO. Once the traders realize a slow down will likely not stop inflation, they’ll jack up rates. Alot of differing opinions on the long end. Place your bets.

  2. DJ commented on Feb 24

    Question about international equity. I have recently shifted some of my equity portfolio (which is underweight) from domestic to international. I did this because I am concerned about the dollar. I think if we have a slow-down it will have to be global since we are their consumers – but if you are overweight international you stand to gain from the currency. Any other thoughts on this?

  3. bo tiepasta commented on Feb 24


    When are you going to change the title of this blog to “The Bear Picture”?


    BR Responds:

    Funny, in 2003 I had people asking me why I wasn’t calling it the Bull Picture . . .

    I’ll just stick with calling ’em as I see ’em.

  4. nate commented on Feb 24

    Individual Investors Shift Assets to Stocks
    by Jane Kim and Jeff Opdyke
    Feb 23, 2006

  5. RogerThat commented on Feb 24

    It’s really too bad that the unravelling of dollar hegemony, industry killing efficiency from the internet (Craigslist/Media), and global wage arbitrage are all hitting the economy at the same time the real estate bubble is popping (See TollBrothers “dumping” comments from yesterday).

    How can there not be a massive poo storm on the horizon? Though I guess, like a farm, things begin to grow again after the poo rains down.

  6. GRL commented on Feb 24

    What do you mean “flat” yield curve?

    At 9:57 a.m. PST, the Pimco website shows the following rates:
    Fed Funds 4.50%
    30 Year 4.51%
    10 Year 4.56%
    5 Year 4.62%
    2 Year 4.70%
    6 Month 4.66%
    3 Month 4.50%

    Using your definition of the 10 yr vs. the 6 month, the curve is inverted by 10 basis points, 15 if you use the 30 year instead of the 10 year.

  7. B commented on Feb 24

    I’m game DJ because I’m bored today. I don’t necessarily have any more insight than you do but it’s a fun topic.

    I think that strategy makes a fair amount of sense depending on what international investments you are buying. I’m not convinced the dollar is going to crater and there are many who’ve bet against it only to be totally crushed. One is Warren Buffet, Mr. Value, who’s been playing in the wrong sand box. His expertise is not derivatives or currency trading. I read where he was into both. He admitted post facto he had no idea what he was doing and he paid dearly. Billions as I’ve heard. So, much for Buffet’s commentary of buy and hold. Doing a little market timing there? Anyhoo, the trend, although appearing to weaken a little is still up for the dollar.

    IMO, there are two possible thought processes following your concerns. One is that the global economies will keep growing and the other is that they won’t. If you believe they will keep growing, that means risk in developing economies will likely remain managable. Buying hard asset economy investments should continue to flourish and markets like Mexico, Canada, Brazil, Australia and Russia will likely outperform. I tend to like Brazil & Canada because they have a very strong currency. I don’t like investing in countries where the currency is weak. Especially against the dollar as you obviously understand based on your comments.

    Then there is the view that the global economy may slow or crater. In that scenario, Japan will likely run the risk of deflating again. Especially if the Bank of Japan starts raising rates and is too agressive. There is also a fair amount of risk around the derivatives markets because Japan has been the world’s leading creditor where every professional investment firm or derivatives desk has borrowed massive amount of ten year Yen denominated monies to play the inflation or fixed income market globally. ie, Borrow at 0% and reinvest in higher return assest. There is a potential this could be a big deal because this trade has been on for as long as ten years for many.

    So, there is tremendous concern that the markets could shudder quite significantly if this comes to pass because all of that “free” money could come unwound and negatively impact the inflation boom and commodity boom we are seeing. May not happen. Especially if our Fed continues to raise rates. But that might mean countries like Brazil, Australia, Canada, Russia and Mexico could get hammered. Many of the best performing international markets are fraught with risk in a situation where we could slow significantly. Political risk, economic risk, social risk, ability to repay debts, etc. China, for example, if this happens and we see a global slow down could suffer from political unrest. You don’t want to be there or be in any economy that might be supplying China. Example, Brazil. Brazil obviously is not as transparent as the US and they are not as economically strong so a domino effect could begin where Brazil’s high yield debt interest rates could increase thus causing more bankruptcies, defaults, etc. Just some examples, not a thesis.

    But, in such a scenario, countries like Western Europe might hold up quite well comparatively. Low PEs, strong dividend stocks, Euro holding up relatively well or even appreciating.

    So, you really need to feel comfortable which scenario is most likely IMO. I think at this point in the cycle, there is above average risk in the global economic system and being invested in what has worked when the Fed was inflating is a low bet odds for a future without bumps. For me, now is a time to keep my money at home where it is backed by the full force of the American government.

    Others may disagree but………that’s my story and I’m sticking to it.

  8. Alex Khenkin commented on Feb 24

    I’d say that everybody and the dog are “international investors” these days, so this can’t bode well for those who get into the game now. Look for things that are not splashed on every investment website/magazine cover. IMHO, of course.
    Small Investor Chronicles

  9. Estragon commented on Feb 24

    DJ – if you haven’t already, you might want to look at the nature of the “international” businesses you’re investing in. Some “U.S.” businesses (eg. Intc) have very significant international sales and may hold up better in a U.S. downturn than say an international business with significant US sales exposure. The domicile of the business’s head office or stock listing may or may not reflect the underlying geography of sales, costs, and profits. All other things being equal, a business with costs in USD but significant export sales should do well in a weak dollar environment. FWIW.

  10. Jack K. Miller commented on Feb 24

    The picture is clear! The 10 year cycle is alive and well. The yield curve flattened in 1986, in 1996 and in 2006. Nothing new here. No recessions either.

  11. DJ commented on Feb 24

    Thanks B & Estragon for your thoughts,
    My international investments are in developed country index funds – I’m no expert on foreign stock picking and I don’t pretend to be. Based on what you said I think I’m doing okay. Maybe a splash more gold.

  12. Mike Scandlon commented on Feb 24

    As I think through this, low long term rates encourage people / firms to borrow against their future earnings to fund consumption today. The prevailing assumption being that inflation and generally positive economic trends will make the gamble worthwhile. The Fed sees this and raises short term rates to encourage saving. But there are concurrently very strong secular forces which discourage saving (stagnant real wage growth for individuals or shareholder activism for firms), so that Fed actions have limited impact.

    I consider the piles of cash being accumulated by U.S. corporations to be low velocity money. The money is swept into short term investments like commercial paper and treasury bills, effectively counteracting increases in Fed Funds and the discount rate. Consequently, so long as this capital remains unavailable to the consuming public via dividends or higher wages, they will continue to borrow long.

    The corporate slush fund has got to stop. A more simple way of putting it is that the U.S. needs a bout of inflation to correct the yield curve. The current Fed policy is unwittingly creating a pressure cooker. When they eventually change tact, the economic correction will be far worse than had they acted sooner.

  13. idoru commented on Feb 24

    I found this FAQ (directly from the Fed) useful.

  14. howard commented on Feb 24

    B, do you have a link for Buffett? as i recall from the 2005 annual report, he made money shorting the dollar in 2004. i’m waiting to see this year’s report, of course, but i could easily have missed some discussion.

  15. Idaho_Spud commented on Feb 25

    No howard, Buffet can now be dismissed as a successful investor because he (gasp) lost money when he went short the dollar. LOL

  16. kennycan commented on Feb 26

    Buffett didn’t do well in 97-99 either. I remember people asking whether he had lost his touch.

    I am not a USD bear against other currencies. Almost every major country in the world has monetary, fiscal, structural, or trade policies, or a combination, that would have an adverse impact on their currency value. I think all currencies may have problems against hard assets.

    I wonder which currencies Warren is long. I also wonder whether he has taken any short dollar bets off the table or whether his losses are on paper only. He has proven patient in the past when strategies appeared to be losing and proved right in the end. I just question whether he has the right trade for the symptoms he is noticing.

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