What Are Interest Rates Telling Us? Part I

Link to Part II
Link to Part III
How far are we from a decent recovery in the U.S. economy? Economists often look for an answer in the relationships among different interest rates. Assuming that cyclical patterns of the past will apply to the badly banged-up economy of 2009, there's a recovery out there somewhere, but it will take a while.

One cup of tea leaves that economists rely on to interpret growth cycles is the shape of the U.S. Treasury bond yield curve. The market of bond investors demands different yields depending on a bond's time horizon -- typically a higher rate the longer the bond has to mature.

When the yield curve is steep -- when there's a large difference between short-term and long-term Treasury rates -- the signal is usually interpreted that credit demand is weak today (the price of borrowing is low) but that it will be higher in the future (the price of borrowing will increase).

One pair of Treasury rates that often serves as a benchmark is the spread between the two and 10 year bonds. The history of these two rates from 1980 to today is plotted in the graph below (taken from the St. Louis Fed's FRED system). The 10 year bond yield is the blue line; the two year is red.

Recessions are illustrated by the gray bars. Note that just afterward, when the economy is just starting to recover, two year rates tend to weaken - or at least they did after the 1991 and 2002 recessions. Then later in the recovery, the gap between the two rates closes as credit demand grows stronger. (The shape of the yield curve goes from steep to flat.) By comparison, the longer term rates hold steady, and it's the short rates that fluctuate more.

At the widest points, September 1992 and September 2003, the two-to-10 year spread was about 2.5 percent. That spread is in the same neighborhood today, and has been since May 2009.

To find out whether the "two-to-10" (I love that bond market talk) is still a reliable measure, I called Mike Pond, head of bond market research at Barclays Capital in New York.

"We're near the peaks we saw in 1992 and 2003, but one thing to remember is that short rates were quite a bit higher in those episodes, especially in 1992," he said: "You can't just look at the slope of the curve -- you have to consider the level of rates as well."

Indeed, the 10-year Treasury yield stands today at 3.5 percent; the St. Louis Fed data, which go back to 1953, tell us that the 10-year was that low, and even lower, from 1953 through mid-1957, but has not been back there since.

"So on the one hand, rates are priced for a normalization of the fed funds curve over time," Pond said, meaning that short-term rates were low and would likely rise. "But on the other hand, rates across the entire curve are still historically low."

The bottom line is that the market is priced, at least over time, for the Fed to normalize rates - for both short and long rates to rise, as economic fundamentals normalize, Pond says: "But that is over a period of time, not the next year or two."

In the next few days I will also look at the current state of corporate bonds, inflation expectations, and credit quality of government bonds.