Bonds Are Signaling a Stronger Recovery

By EMILY BARRETT and JOANNA SLATER A closely watched bond-market measure of investor optimism hit a record Monday, amid signs the U.S. economy's recovery is strengthening. That measure is the yield curve -- the difference between short-term and long-term interest rates on government bonds. That number is at its highest level ever, surpassing the record set in June, and signals that investors are expecting a stronger economic turnaround ahead. The milestone comes amid a broad sell-off in government bonds, as investors shift money into riskier assets like stocks in anticipation of stronger growth. Last year, investors dumped stocks and sought the safety of government bonds amid the financial panic. That drove up the prices of government debt, and thus drove down the yields on some to record lows. That trend has reversed. On Monday, stocks jumped on positive words from Wall Street analysts and news of acquisitions in the mining and health-care sectors. The Dow Jones Industrial Average rose 85.25 points to 10414.14, putting it in positive territory for the month. The Dow's strongest component was Alcoa, the aluminum maker whose business is closely tied to the economic cycle, which rose 7.9%. Low trading volumes at the end of the year may also be exaggerating market movements. The interest-rate development is good news for banks, which normally borrow at short-term rates and lend at long-term rates. The bigger the difference, all else being equal, the bigger their profit. Higher profits mean banks can refill their coffers, which have been drained by bad debts, and return to health. The yield curve steepens when the Federal Reserve, which controls short-term interest rates, keeps them low to spur the economy. But at the same time investors, expecting growth to resume and with it the possibility of inflation, sell longer-term government bonds, which sends their prices down and their yields up. The difference between the yields, in this case on 2-year and 10-year notes, is the main gauge of the yield curve. On Monday, the difference reached 2.81 percentage points. The gap between short- and long-term yields tends to stretch on the way out of economic trouble. Before this year, the yield curve was last near these levels in 1992 and 2003. In both instances, the economy was pulling out of a recession, and staged a sustained recovery. However, on both occasions it took a year or more before the Federal Reserve decided the economy was strong enough to warrant interest rate increases. The gap could widen further, said Tony Crescenzi, a portfolio manager at Pacific Investment Management Co. in Newport Beach, Calif. The previous peaks "didn't occur until the expansion was gaining some steam, and we don't know yet that's the case," Mr. Crescenzi said. The steeper yield curve is being driven by investors selling off government bonds. The 10-year Treasury tumbled Monday, sending its yield up to 3.686%, the highest since mid August. The yield on the 2-year Treasury rose to 0.872%. The widening gap stems from a bout of optimism about the U.S. economy, combined with a sense that the Federal Reserve is still months away from raising borrowing costs. The gap is great news for banks, because they can borrow for the short term at low rates and then lend at higher long-term rates. In the 1990s, a steep yield curve helped pull the U.S. banking industry out of a catastrophic crisis, making it much easier for financial institutions to borrow money at a lower rate, lend it at a higher rate, and put the difference in their pockets. By the end of the decade, earnings growth, fueled by the favorable gap in interest rates and strong consumer spending, had risen to as much as 20% a year. A rash of better-than-expected economic data in recent weeks has pushed investors to expect better growth. That could lead to inflation, which could eat away at the value of government bonds, making them less attractive. Meanwhile, the Fed has said it intends to maintain its benchmark interest rate near zero for an extended time, which helps keep a lid on yields of shorter-term government securities. "The Fed isn't going anywhere, at least for now," said Dan Greenhaus, chief economist at Miller Tabak & Co. As a result. At this time last year, the gap was 1.27 percentage points. At the crisis onset, in June 2007, the yield curve was inverted: a phenomenon in which short-term yields are higher than long-term ones, a development which often augurs a recession. Write to Emily Barrett at emily.barrett@dowjones.com and Joanna Slater at joanna.slater@wsj.com