Will there be a business slowdown next year? The kind that could affect yields on the Treasuries and CDs you invest in?
Some economists think “yes,” based on what’s happening with a complicated little chart they use to keep track of the future direction of interest rates. The chart is called a “yield curve,” and while the average Joe knows zilch about such things, I’ll try to explain it to you.
Examining a yield curve is like a palm reader trying to study the lifelines on your hand. In simple language, it’s a line that shows the relationship between, for example, Treasury yields and the maturity dates of the Treasuries.
Visualize the chart, with the interest rates running up the left side and the maturities across the bottom–from short-term on the left to long-term on the right. As you plot the points to draw the curve, note that normally the longer the maturity, the higher the yield. That applies not only to Treasuries but to bank CDs and bonds as well. A one-year CD pays more than a six-month CD, a five-year account earns more than a one-year, and so on.
As a result, the line (or curve) usually slopes higher and higher as the maturities get longer and longer. Why do the longer maturities pay higher yields? One reason is because investors who lock up their money for longer periods want to be compensated for the extra risks they take, including higher inflation that would eat up more of their earnings.
Over the past several months, the Treasuries yield curve has been getting flatter as long-term maturities have risen more slowly than shorter maturities. And that, say the economists, points to a probable economic slowdown in 1998.
For example: Last April, the three-month Treasury bill was yielding 5.18 percent and the five-year Treasury note 6.75 percent. That was a difference of 1.57 percentage points. But by October, the difference had narrowed to only about a percentage point. The same kind of thing happened with other short- vs. long-term investments.
You could explain it another way: When experts who set interest rates believe the long-term numbers (such as yields on five-year CDs, or on 10- or 30-year bonds) will be lower down the road, they pull their horns in. Say you’re a banker selling five-year CDs at 6 percent, but think that yields might be a full percent lower a year or two from now. Why lock yourself into paying customers that much until the year 2002? You’re better off lowering the yield this week to maybe 5.75 percent or 5.5 percent to reduce your costs, right?
Meanwhile, the bank might keep its short-term interest rates unchanged. The upward slope of the curve starts disappearing.
Palm-reading economists see different signals in other shapes of the yield curve. For instance, back in 1981 the curve became “inverted’–short-term rates were a lot higher than long-term rates. That foreshadowed the 1982 slowdown. On the other hand, in 1986 there was a “positive” curve with a steep upward slope, as long-term yields raced ahead of yields on shorter maturities. That screamed an inflationary threat.
Why do the experts now predict a slowdown?
Bruce Steinberg, chief economist at Merrill Lynch, was quoted by American Banker as saying, “Previously when the yield curve flattened to this extent. GDP (gross domestic product) slowed to around 2 percent the next year.”
Yet, that theory runs smack into a different opinion by other economists who foresee the Federal Reserve raising rates to prevent inflation. But that’s not so odd, explains Steinberg, noting that the yield curve usually flattens whenever the Fed boosts short-term rates, anyway.
If a slowdown indeed is in the works, consumers would feel it several ways. They wouldn’t earn as much interest on investments, and might have to curtail their spending. Mortgages and other loans would become cheaper. Corporations also would benefit through lower borrowing costs that, ironically, could restimulate the economy.
None of this is engraved in stone, for the simple reason that anything–from Saddam Hussein’s behavior to changes in the Consumer Price Index–could trip up all these marvelous theories and suddenly send out a whole bunch of new signals. This could reshape the yield curve in a matter of weeks.
What should your investment strategy be against that crazy backdrop? Surely 10 different brokers and bankers will give you 10 different answers. Some guys I know swear that the place to be on the current yield curve slope is neither at the far end or short end, but somewhere in the middle, between one-year and two-year maturities. But then, you might be a better palm reader then they are.
– Credit tip. Always pay more than the minimum amount due on your credit-card statement. Paying only the minimum can add many years to paying off the balance.
