YIELD CURVE CONTINUES TO STEEPEN -- SELLING IN LONG BOND ETF SUGGESTS SHORTER MATURITIES -- TIPS OFFER MORE INFLATION PROTECTION -- BOND/STOCK RATIO NOW FAVORS BONDS
STEEPENING YIELD CURVE IMPLIES ECONOMIC WEAKENING ... I wrote an article on the steepening yield curve on January 31 and have been asked to revisit the question of bonds and bond yields. One question I received was how to create Chart 1. The "yield spread" usually refers to the spread (or difference) between the yield on the 2-Year and 10-Year T-note. There are two ways to create Chart 1. To make your chart look like Chart 1, go to PerfCharts and insert in the first two boxes the two necessary symbols you want to compare. In this case, they would be $UST2Y (2-Year Yield) and $UST10Y (10-Year Yield). Then, click on the first name (UST2Y) to make it the zero line. Stretch the time box at the bottom right all the way to the left of the chart to see ten years of action. [Another way is to plot a $UST10Y/$UST2Y ratio]. Chart 1 shows that the spread between the 10-Year T-note Yield (blue line) and the 2-Year Yield has been steepening since the middle of 2007. In reality, both yields have been falling since then. But the 2-year yield has been falling faster than the 10-year (See Chart 2). The main reason for the widening (or steepening) in the spread between the two yields is that short-term rates fall faster than long-term rates when the Fed is in an easing mode. [A second reason is that long-term yields are more susceptible to inflation worries]. The last time the yield curve resembled the present situation was in 2001 in the midst of a recession and a bear market in stocks.
Chart 1
Chart 2
THERE'S GOOD AND BAD NEWS IN THE YIELD CURVE ... The good news is that a steepening yield curve is a necessary pre-requisite for an eventual upturn in the economy. [Another good piece of news is that the stock market usually bottoms about halfway through a recession, well ahead of the economic rebound]. The bad news is that it's hard to tell how long that process will last. The present situation is made more difficult by the fact that finances of banks are very strained as a result of subprime writedowns. That makes them less able, or more reluctant, to make loans. The ability and willingness of banks to make loans to businesses and individuals is why a steepening yield curve eventually helps the economy. In the early stages of an economic slowdown, bond prices do better than stocks (bond prices rise as yields fall). That's been the case since midyear (See Chart 10). Are bonds still a good bet? And, if so, which bonds?
Chart 3
COMPARING BOND ETFS... Chart 4 compares the performance of four T-bond ETFs since last July, when money started to flow out of stocks and into bonds. The four ETFs represent different durations in the yield curve. Through the middle of January, the top performer was the 20 + Year Bond Fund (TLT). Next in line was the 7-10 Year Bond Fund (IEF). That was followed by 3-7 Year Bond Fund (IEI), which was followed by the 1-3 Year Fund (SHY). The chart shows that the longer duration bonds did better than the shorter-term ones. That situation, however, may be changing. Over the last month, longer duration bond ETFs have fallen faster than shorter-duration funds. That could be a reaction to new fears of inflation arising from the aggressive Fed easing and a further steepening of the yield curve. That's because the long bond is the most vulnerable to fears of rising inflation. That also suggests that the long bond may no longer be the best place to be on the yield curve.
Chart 4
TIME TO SHORTEN BOND DURATION... Charts 5 through 7 compare three bond ETFs with different time durations. Chart 5 shows that the 20+ Year T Bond Fund (TLT) has broken its 50-day moving average (blue line). Its the weakest of the three ETFs. Chart 6 shows the 7-10 Year T-Bond Fund (IEF) still trading above that initial support line. Chart 7 shows that the 3-7 Year T Bond Fund (IEF) is holding up even better. That suggests to me that it makes sense to start moving away from the long bond to shorter maturities on the yield curve.
Chart 5
Chart 6
Chart 7
WHAT ABOUT TIPS ... Which brings us to TIPS (Treasury Inflation Protected Securities). TIPS are bonds that have some protection against inflation built into their pricing. That would seem to make them a good alternative in the current environment of falling yields and rising inflation pressures (record high commodities). Chart 8 shows the iShares Lehman TIPS Bond Fund (TIP) over the last year. [TIP was the top performing bond ETF over the past year]. It has slipped a bit during February, but is holding over its 50-day moving average. The ratio below the chart divides the TIP by the 20+Year Bond ETF (TLT). The rising ratio since the start of 2008 shows that the TIP is starting to do better than the TLT. That may mean that bond investors are starting to favor TIPS for more insurance against inflation. That's not a bad idea.
Chart 8
BOND/STOCK RATIO FAVORS BONDS ... A bigger question is whether the current environment favors a heavier investment in bonds or stocks. The next two ratio charts may help answer that question. Chart 9 plots a ratio of the price of the long Treasury Bond divided by the S&P 500. The falling ratio from 1980 to 2000 certainly favored stocks over bonds. The ratio swung in favor of bonds at the start of 2000 (up arrow) for the first time in two decades. Chart 10 shows what's happened to the bond/stock ratio since 2000. Bear in mind that a falling ratio favors stocks, while a rising ratio favors bonds. A rising ratio from 2000 to the end of 2002 clearly favored bonds (bond prices rose as stocks fell from 2000 to late 2002). The falling ratio from early 2003 to mid-2007 clearly favored stocks (the S&P 500 doubled in price during those four years). The ratio, however, has been rising since mid-2007 and is now at the highest level in two years. That tells us that the bond/stock ratio now favors a heavier investment in bonds than in stocks. The simplest way to do that is through a bond mutual fund or Exchange Traded Fund.
Chart 9
Chart 10
