Tuesday, July 6, 2010

Yield Curve Flattens as Anxiety Deepens

The U.S. Treasury market is flashing signs of anxiety over the global economic outlook: The yield gap between long-dated and short-dated bonds has narrowed significantly in the past two months.

In a growing economy, the gap between the typically lower yields on short-dated securities and the higher yields earned by longer-dated notes and bonds typically widens. That is because investors demand higher returns to hedge their investments against inflation.

That was the case in the first quarter, when investors took the upbeat view that an economic recovery was gaining traction. The benchmark yield curve, or the yield premium of the 10-year note over the two-year note, widened to a record 2.929 percentage points in February.

But more recently, worries over the economy and the potential for deflation have been revived, thanks to both the euro zone's debt problems and weak U.S. data. In return, investors in recent weeks have piled into long-dated Treasurys, driving down their yields and flattening the same curve by more than 0.60 percentage point from its peak.

The curve touched 2.282 percentage points Thursday, its flattest since May 2009. Late Friday, that gap was only slightly steeper at 2.336 percentage points, as the 10-year note yielded 2.977% and the two-year note yielded 0.641%. Bond prices move inversely to their yields.

"The flattening has reflected increased anxiety that the global economy could relapse," said Ward McCarthy, chief financial economist in the fixed-income group at Jefferies & Co. "This will exacerbate the Federal Reserve's concerns about disinflation evolving into deflation."

Jeff Michaels, co-head of fixed income at Nomura Securities International in New York, noted that the move in the yield curve also suggests "all the regulation and the fiscal-authority measures globally are going to crimp any moderate growth we would have had."

Regulation covering the banking sector will decrease leverage in banks, causing a reduction in loans and in other credit availability, said Mr. Michaels. Countries in Europe, including Germany and the U.K., are spending less, he added. "Cutting spending when growth is anemic, if positive at all, will cause [another contraction in] gross domestic product."

A flattening curve has pushed down long-term borrowing costs for consumers and businesses. The U.S. 30-year fixed mortgage rate tumbled to a record low of 4.58% last week, a boon for homeowners seeking to refinance their loans. On the other hand, a flattening curve lowers net interest margins for banks by reducing the spread between their funding costs and the rates at which they lend.

With yields on short-dated Treasurys well-anchored as long as the Fed maintains its key policy rate near zero, the benchmark curve will flatten further by the end of the year, said Steven Major, global head of fixed-income research at HSBC Holdings in London. HSBC's current forecasts are for the 10-year note's yield to fall to 2.7% by the end of the year, with the risk being that it could go even lower.

Should the 10-year note's yield fall below 2.5%, that would imply the benchmark curve could flatten by an additional one percentage point from current levels, Mr. Major said. He has consistently forecast bond yields to drop through 2010, encouraged by weak economic growth and euro-zone sovereign-debt risk. Ultimately, the 10-year note's yield is likely to return toward the record low of 2.034% set at the height of the global financial crisis in mid-December 2008, he said.

Meanwhile, with government policy makers emphasizing fiscal austerity, some market participants argue that the Fed will be forced to restart its asset-purchase program to keep the U.S. from sliding back into recession.

"The key point is to stimulate growth," said David Rosenberg, chief economist and market strategist at Canadian asset manager Gluskin Sheff & Associates Inc. in Toronto. Fed Chairman Ben Bernanke "already showed us how aggressive he can be. The key question is whether the measures are going to work."

Write to Min Zeng at min.zeng@dowjones.com

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