August 1, 2005
TEN MINUS TWO EQUALS…???
Wall Street likes to keep an eye on the spread between the 10-year Treasury Note and its two-year counterpart. This particular view of the money curve has been delivering more than a little bit of drama lately, but whether that translates into clarity about the future is another matter entirely.
In normal times, a 10-year Treasury yields more than a two-year for the obvious logic that lending your money, even to a top-rated borrower such as Uncle Sam, for longer stretches requires additional compensation. But these aren't normal times, or so the spread between the two- and 10-year Treasuries imply.
The 10-year Note at the close on Friday offered less than 30 basis points more than a two-year Note. That represents a sharp fall from around two years ago, when the spread was above 250 basis points. Friday's was the lowest yield premium in the 10-year over the two-year Treasury since early 2001, a period when the economy was struggling and declines in quarterly GDP reports were very much a sign of the times. In fact, the spread has made a habit over the years of falling as an economic stumble approached.
But in the wake of the latest update on the economy's pace, released on Friday, the argument that recession lurks just around the corner seems more than a bit far-fetched. Or, might we suggest, the burden of proof lies with the recessionistas.
The economy, in fact, is bubbling along quite nicely, thank you very much. The Bureau of Economic Analysis advised last week that the gross domestic product advanced by 3.4% in the second quarter. Although the economy's pace of growth has clearly been slowing over the past year, it's not slowing fast enough, or in any compelling way to warrant yields that are within kissing distance of one another on the two- and 10-year Treasury fronts.
''We're seeing very strong growth momentum," Nariman Behravesh, chief economist at Global Insight, told the Boston Globe over the weekend. ''This recovery has staying power."
Support for that brand of optimism came anew this morning, with the release of the ISM Manufacturing Index, which reveals another jump in manufacturing activity for July. "An improved rate of growth in new orders and production continues to drive improvement in the sector," the accompanying press release announced. "It appears that the sector hit a low point in May, and has rebounded nicely in June and July."
Yet when it comes to pricing bonds, there's still less than consensus opinion prevailing in the world at large. Someone clearly believes the 10-year is a debt instrument worth owning even though its premium over the two-year is wax-paper thin. If and when the 10-year's yield slips below the two-year, which could be at any moment, the yield curve will be officially inverted. What then? Would recession drop out of the sky like some unannounced bird of prey swooping down on a napping rodent?
Barring some unforeseen event, it's tough to imagine an inverted yield curve in the here and now accompanying economic activity other than what's been standard fare of late. In fact, some dismal scientists feel compelled to forecast a pickup in GDP's pace in this year's second half. "I think there's a good chance [the rate of real quarterly annualized increase in GDP] go could above 4 percent in the third and fourth quarters," William Mulvihill, economist at Claymore Securities in Chicago, predicts by way of Saturday's Chicago Tribune.
And then there's today's Wall Street Journal (subscription required), which carried the front-page story on analysts "who're lifting projections for U.S. economic growth in the second half on expectations that the nation's retailers and manufacturers will be restocking inventories and ramping up production to keep up with demand." The article relates that the slowdown in second-quarter GDP was a byproduct of companies slashing inventories in anticipation a recession—a recession that's yet to rear its ugly head. Rebuilding those inventories, in the face of continuing strong consumer demand and robust industrial production, suggests that that the third- and fourth-quarter GDP reports will reflect more economic humming.
The economic cycle, to be sure, is not dead, but neither is it about to elbow investors in the ribs next Thursday. Squaring that with a yield curve that potentially could invert on the next trade raises more than a few questions, and for the moment a paucity of answers, or at least persuasive ones from the perspective of your editor. There are, to be sure, many theories, and more than a little speculation fueling the atmosphere in the bond-trading pit. Some are good, some less so. Meanwhile, it's a good time to be a trader. But the jury is decidedly still out when it comes to dispensing the same advice to investors in the fixed-income market.
Posted by jp at August 1, 2005 5:19 AM