James Stewart on the Yield Curve

From the WSJ:

The most prevalent explanation is that buyers of the long bond accept the lower yield in anticipation of a recession, which is likely to drive long rates even lower. In this theory, such expectations in the markets become self-fulfilling. But I have yet to see any empirical data to support this notion.
In any event, inverted yield curves rarely last long. At this juncture, either long rates will rise, short rates will fall, or some combination of the two will occur, restoring the normal upward slope. You don’t want to own long-term bonds when rates are rising.
To me, this makes it even more paradoxical that investors were so keen for those low-yielding 30-year bonds. It wouldn’t take many cuts in short-term rates for the Fed to restore the slope of the yield curve. But how much lower can long-term rates fall? True, rates in deflationary Japan got close to zero, but the possibility of deflation in the U.S. seems a distant memory with gold trading at well over $500 an ounce. The likelihood that long-term rates will go above 4.48% over the next 30 years strikes me as close to a certainty.
And what if the yield curve turns out to be wrong this time, and there isn’t any recession? Not only will economists return to the drawing board, but that means economic growth will continue, putting more upward pressure on long-term rates.
This seems yet another argument for investing in shorter maturities at today’s relatively high rates. Short maturities, like the one- to three-year bank certificates of deposit I’ve recommended, have little risk of principal erosion even if rates rise. Meanwhile, you can collect close to 5%, and if the Fed continues its rate-rising campaign, you’ll soon be able to earn even more.

Posted by on February 15th, 2006 at 10:53 am


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