Many experts think this inversion is different.
By Marla Brill
Fixed-income investing has been turned on its head
by an inverted yield curve that lasted longer than many expected, and
turned the words "high-yielding cash investments" from an oxymoron into
a believable phrase.
The high yields available from virtually risk-free short-term securities has been a magnet for money market funds, which attracted nearly 20 times the net cash flow that went into bond funds during the fourth quarter of 2005. In December alone, inflows into money market funds reached nearly $47 billion, compared to outflows of $8.9 billion for the same period a year earlier.
The public's appetite for market funds, certificates of deposit, Treasury bills and other short-term investments remains healthy. A study commissioned by Northern Trust Corp., Wealth in America 2006, revealed that 20% of investors with $1 million or more in investable assets would like to increase their cash allocation this year. Those investors had an average of 13% of their portfolios in cash-much higher than the 4% allocation the firm recommends. The trend was particularly notable among millionaires 35 and younger, who had 19% of their investments in cash.
Tepid feelings about the stock market may account for at least part of the shift. More than two-thirds of the respondents said they were oriented toward preserving their wealth as opposed to growing it further this year, suggesting that they are cautious about making big adjustments to their portfolios and are taking a wait-and-see attitude about the market. Their overall expectations for market returns in 2006 are just 6%, well below historic norms.
At a time when earning mid-single-digit returns requires little effort and almost no risk, those modest expectations certainly make stocks or intermediate-term bonds a harder sell. In mid- March, when ten-year Treasuries were yielding 4.7%, investors could get a 4.8% yield from a six-month Treasury bill, and 4% from a plain-vanilla taxable money market fund.
But experts caution that heeding the siren call of high short-term rates with radical asset allocation moves, or positioning portfolios for a recessionary environment that has historically followed such inversions, is probably unwise. "I know it's dangerous to say that this time is different, but I believe it is," says Jim Midanek of Midanek/Pak Investments in Walnut Creek, Calif. "The factors that drove previous inversions are not in place this time around."
Inverted yield curves occur when short-term Treasury securities yield more than long-term bonds. According to an analysis by the Federal Reserve Bank of San Francisco, each of the six recessions since 1970 was preceded by a yield curve inversion. Those recessions occurred six to 12 months after the curve inverted. The last time it happened was in 2000. That inversion lasted for nearly a year, and signaled the beginning of a post- bubble economic downturn.
When the latest inversion surfaced again in the waning days of 2005, some observers predicted it would soon disappear. It hasn't. The yield curve remained flat through most of January, but began assuming a downward slope late in the month and stayed that way through February. At its widest point late in that month, the yield on two-year Treasuries exceeded the yield available from ten-year Treasuries by 16 basis points.
Inversely sloped yield curves are not sustainable, since eventually either short-term yields will fall or long-term yields will rise. The question now is which will happen, and when. With the Fed expected to continue rate tightening and demand for longer-term bonds still strong, experts say investors can probably expect short-term yields to fluctuate between exceeding bond yields slightly and staying a tad under them over the next few months.
The exact configuration the curve will take through
the rest of the year remains uncertain. "The yield curve is flat at
this moment but it could invert again by the end of this conversation,"
notes investment strategist Brian Gendreau of ING Investment Management
during a recent telephone interview. In Midanek's view "the trend is
not likely to disappear soon. The yield curve will likely remain
modestly inverted for the next several months." And Tony Malloy,
manager of the Mainstay Floating Rate Fund, believes that "we are more
likely to have a flat curve with parallel shifts upward on the long and
Even if short-term yields exceed those available from longer-term securities periodically as the year unfolds, many believe that the classic explanation of an inverted yield curve as an economic slowdown probably doesn't apply this time around. In previous recessions following a yield curve inversion, both short-term and long-term rates were on the rise. Now, only the short end is moving up because of the Fed's tight monetary policy. On the long side, foreign buying of U.S. Treasuries and strong demand from pension funds have supported bond prices and kept their yields from rising, bringing them close to short-term rates. According to a study by the Federal Reserve, foreign buying alone has shaved some 150 basis points off of Treasury yields. "The purity of the yield curve as a predictor of the economy has changed," says Quincy Krosby, chief investment strategist at The Hartford. "It's just not as accurate anymore."
Malloy sees the yield curve's modest inversion as a sign that its shape is more of a technical issue than a signal for an impending recession. "In the past, when short-term yields exceeded long-term yields by 50 basis points or more, people typically saw it as a sign of economic weakness. We're not seeing anything to suggest that anything of that magnitude is on the horizon." He adds strong growth in corporate profits, healthy GDP growth and increased government spending support the idea that the economy will continue to move along at a healthy pace rather than struggle.
Despite assurances that a recession appears unlikely, many investors are taking a cautious stance on the bond market, while giving more play to cash and shorter-term securities.
"This is not an exciting time to be a fixed-income manager because a flat-to-inverted curve makes it tough to add value," says David Thompson, chief investment officer at Dwight Asset Management in Burlington, Vt. "At this point, the key is not to do anything stupid and keep your powder dry."
Given increased uncertainty about monetary policy and foreign demand, the firm expects bond market volatility to increase this year. Foreign capital flows to the U.S. could decrease with shifts in global savings and investment opportunities, and the strong foreign demand that has sustained bond prices could teeter with a sharp decline in the value of the dollar, notes a recent report by chief economic strategist Jane Caron. If the dollar declines against foreign currencies, international carry trades where investors have borrowed in lower-yielding foreign currencies to invest in higher-yielding U.S. bonds could unwind. And improvements in foreign economies might drive yields up for non-U.S. securities, making them more competitive with U.S. bonds.
At ING Investment Management, the uncertainty has recently led to adjustments in asset allocation guidelines that make greater use of cash investments. Early this year, the firm recommended a 75/25/0 stock, bond and cash mix in its model portfolios for institutional clients. Now, the split is a more cash-focused 75/15/10 mix.
"There is no risk premium being priced into Treasury bonds," observes ING investment strategist Brian Gendreau. "Investors are not getting compensated for the risks that the market may be wrong about inflation or about Fed tightening."
But the outlook for bonds could improve later in the year when the Fed's current rate-raising campaign nears completion. "I'd wait a few months to put money into bonds, and in the meantime invest more than usual in cash and stocks," he says.
Midanek, who compares today's precarious interest rate environment to the overheated technology stock environment of the late 1990s, believes that "this isn't the time to be in a typical market-weighted bond fund." With government spending out of control and rising costs, he says, "the threat of inflation is very real." He advises investors to stick with ultrashort- or short-duration maturities and high-quality government securities. "There are a lot of dollars chasing too few securities on the short end, so there isn't much yield advantage for taking corporate credit risk with a short-term corporate bond fund," he says.
Krosby counsels investors to "stay close to the short end of the bond market. This is a good time to let any unwinding take place and see where things end up. And floating rate funds or TIPs will be a good bet if inflation heats up."
She believes investors should also keep an eye on Treasury yields for clues about which kinds of stocks to invest in. "In the past, when ten-year Treasury rates went over 5%, large-cap companies have usually done well," she says. "In the U.S., large-company stocks are the most attractively valued asset class right now."