Are Bond Yields Really Signaling Recovery?
Ron DeLegge, Editor
December 22, 2009

SAN DIEGO (ETFguide.com) – A growing yield difference between short and long term government bonds is signaling economic recovery, according to some on Wall Street.

While the Federal Reserve in its last meeting reiterated its goal of keeping short term interest rates near zero, it’s handle on long term rates could be slipping. Even though short term interest rates are still at record lows, long term rates on government debt have been steadily rising. Does it mean economic recovery or more problems?

Yield Curve Basics
The yield curve describes the relationship between interest rates by comparing the yields of bonds with similar credit quality but varying maturities. Typically, a yield curve plot is graphed out to visually show the differences in yield.

Normally, the yield curve is positive. That’s because investors that are ready to tie up their money for longer periods of time are typically compensated for accepting additional risk with higher yields.

If short term interest rates are lower, it signals a positive yield curve. If short-term rates are higher, it’s a negative yield curve. If there’s negligible difference between both, it’s referred to as a flat yield curve.

Analysts and traders will closely watch the yield curve in an attempt to forecast the future direction of interest rates.

Pressing the Rewind Button
During the 2007-08 financial crisis the bond market was pushed to such extremes that yields on short-term debt were actually higher than long-term debt. This was very unusual. People weren’t so much worried about a return on their capital as they were more concerned with a return of their capital. Capital preservation was name of the game.

The negative yield curve during this tumultuous period was telling of problems not just with the credit market but with the overall economy. It was a sinking ship that triggered emergency intervention. And massive amounts of capital were dumped into the financial system by the federal government. It was their noble attempt to manipulate the market up. It worked in the short run, but what about over the long run?

Today’s Bond Market
The difference between short term and long term interest rates on U.S. government bonds is indeed growing. The 30-day SEC yield for short term government bonds (NYSEArca: SHY) is 0.59% whereas with long-term bonds (NYSEArca: TLT) it’s a much higher 4.19%. Simply put, the long-term borrowing costs for the U.S. government are going up. With ballooning trillion-dollar deficits, how could this possibly be good news? Isn’t it the opposite? Main Street and Wall Street overleveraged themselves and now it’s the government. Yet, the results of the latter could have far more catastrophic consequences, don’t you think? 

The bond market’s other message (which has fallen on deaf ears) is that investors have become little concerned with risk. The very same group that piled into government bonds looking for safety last year is now piling into risky asset classes like emerging market stocks (NYSEArca: EEM), technology stocks (NYSEArca: XLK) and frontier markets like Turkey (NYSEArca: TUR). Simply put, the current appetite for risk is insatiable. 

Yet, a steepening yield curve is Wall Street’s latest explanation that a powerful economic recovery is now underway. It’s this piece of evidence that will prove them right and everyone else wrong. Never mind the depressed job market, never mind debt laden consumers, never mind the general public’s rising tax burdens or the ongoing turmoil in both the commercial and residential the real estate market or any other negative news. “This time is different,” they can be heard proclaiming.

Which Compass Will You Believe?
How much faith would you put in a broken compass? The reasonable person asks, “If it didn’t work before, why should it work right now?”

Perceptive travelers aren’t tricked by a broken compass. You don’t need to bump your head against a Sequoia tree to know you’re in the middle of a forest. The mountain sized leaf piles and mountain lion paw prints are good indicators of your actual location. Neither does the sun’s existence mean you’re any safer or closer to home.

Likewise, perceptive investors don’t rely on data from questionable or broken sources. The ETF Profit Strategy Newsletter was quick to alert its subscribers to the overly pessimistic tone of the Wall Street’s broken compasses back in March. At that time selling had reached a pinnacle. And while the rest of the Wall Street’s broken compasses were negative, the newsletter turned positive. What about today’s market?

Every issue of the ETF Profit Strategy Newsletter includes a detailed short, mid and long-term analysis of the stock market and other asset classes, along with common sense strategies to survive and thrive in the current financial environment.