Tuesday, January 22, 2008

Yield curve strategy nears turning point

When the Federal Reserve knocked short-term rates down 3/4%, I took at look at the current yield curve to see if it has become attractive. It still looks flat to me, so I'll stick to the PIMCO Total Return fund for now.

The Total Return fund returned 9.07% last year compared to 5.49% for the S&P 500 with dividends invested. That's pretty good, but I made the call about a year too early. The S&P 500 was up 15.80% in 2006 compared to just 4.0% for PIMCO. So far this year, the index is down 9.67% and the bond fund is up 2.66%, so I'm not complaining about being early. In fact, I think the nature of the yield curve signal requires an early switch when the curve becomes inverted.

As we saw today, the Federal Reserve controls the short end of the yield curve. When it wants to stimulate the economy, it pushes down rates and tries to raise them when the economy seems to be functioning well. Market forces controls the long end of the curve. Since there is little default risk in US bonds, the market mostly concerns itself with beating inflation over the life of the bond. In general, the longer the bond the more yield investors demand to compensate for inflation risk over the life of the bond. Since inflation and economic activity are closely related, you could rephrase those goals so that the Federal Reserve is fighting inflation and the bond market is predicting future economic activity, but I think that's overly complicated.

Under normal circumstances, the curve slopes up as the term of the bond increases. When the short-term rates go up because the economy is functioning well, the long-term rates go up too because of an increased expectation of inflation. On the other hand, when the economy is in trouble, there isn't as much inflation to fear in the future. So there is something strange going on when the curve is inverted. Specifically, the Federal Reserve thinks the economy is doing fine and the bond market isn't worried about inflation, which seems like the best of all worlds—the so-called Goldilocks economy.

And for a while, it is the best of all worlds as the economy hums along with no sign of rising prices. But it also means that most people let down their guard against "bad things". There is also an inherent risk that people will borrow long and loan short to profit off of the inversion. When the curve snaps back to normal, the profit vanishes and the position becomes an expensive liability. Leverage will increases the pain. You might think this only happens to hedge funds and Wall Street types, but how many stories have you heard recently about people taking money out of their home's equity to buy cars or go on vacation? One of the reasons people were willing to do that sort of thing was that borrowing against home equity was so cheap and easy.

So an inverted yield curve marks the moment when everything is working about as well as can be expected and conventional wisdom says there is nothing to be worried about. And there isn't until suddenly, there is a lot to worry about. The Federal Reserve responds to economic trouble by pushing down the short end while the market responds to future inflation by demanding more yield on the long end. When we see a normal to steep curve, the fear permeates the economy and it's time to switch from bonds to stocks.

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