The troubling mystery of the 'yield curve'

For those who follow bonds, it's a mystery as engrossing as a Sue Grafton novel: How can long-term interest rates fall when the Federal Reserve is pumping up short-term rates?

That's not supposed to happen. In theory, investors should get a bigger return for taking the extra risk of tying up their money for a longer period. That's especially true when inflation is rising, oil prices have soared, and the economy has been growing.

This narrowing of the gap between short- and long-term rates is called a flattening of the yield curve. And it's a concern. If short-term rates actually exceed their long-term cousins, then wild and potentially harmful things can happen to the stock market and economy.

So why are rates falling on long-term United States Treasury bonds?

It's a "conundrum," states Stephen Roach, chief economist at Morgan Stanley, a major investment bank.

Even Alan Greenspan, chairman of the Federal Reserve, is scratching his head. It's "clearly without recent precedent," he said a week ago.

Here's where we stand: The Fed controls short-term rates, specifically the Federal Funds rate. Since last June, it has pushed up its interest rate eight times, from 1 percent to 3 percent. Another hike is expected when Fed policymakers meet later this month. In the same 12 months, however, yields on 10-year Treasury bonds have fallen about 0.8 percentage points to 3.94 percent. Yields on corporate bonds fell even more.

That's a narrow margin by historical standards - but not unprecedented. Several times in the past, long-term bonds have actually yielded less than short-term notes.

The last time it happened - in early 2000 - it presaged the bursting of the dotcom bubble and the subsequent recession in the US.

But that's "not a hard and fast rule," cautions Brian Reynolds, chief market strategist for M.S. Howells & Co., an investment boutique in Scottsdale, Ariz., serving more than a hundred hedge funds. The yield curve reversed in the last week of 1994, and stock prices surged gloriously for three years.

And though long-term rates have dipped faster in the past year than in many decades, he notes, Mr. Greenspan didn't predict a slump, nor budge from the Fed policy of raising interest rates at "a measured pace" in the months ahead.

Bond yields have a huge impact on the economy. They determine how much business pays when it borrows money for expansion, and how much consumers pay on loans for new homes.

If long-term rates remain low, they could stimulate another round of mortgage refinancing by American households, suggests Harald Malmgren, an economic consultant in Washington, D.C. That could lead to further escalation of house prices, something the Fed wouldn't want, given widespread worry about a real estate bubble.

Already, interest-only and low-rate adjustable mortgage loans are making many householders more vulnerable to payment shocks should interest rates rise sharply, warns Harvard University's Joint Center for Housing Studies in a report scheduled to be released Monday.

But that shock could be a few years away. Today, there is what Greenspan describes as a "remarkable worldwide environment of low long-term interest rates." In a speech last week, he listed several possible explanations for this phenomena.

One popular view is that the bond market is signalling weakness ahead in the economy. Mr. Reynolds suspects that's the case. But, he adds, the long-term bond market has become something of an automatic stabilizer for the economy. Long-term rates slip when the economy slows, so mortgage refinancing picks up. That puts more cash in the hands of householders, boosting the economy.

Another thesis is that long-term bond yields have been pushed down by high demand for US bonds from abroad and from pension funds stacking up assets as baby boomers prepare for retirement. Foreign central banks piled up almost $400 billion of US bonds in 2003 and probably more in 2004. Private investors also sank huge sums in the US.

Mr. Malmgren regards it as a "flight to quality" at a time of economic, political, and security turbulence, with the US bond market offering higher yields than those available in Europe or Japan.

Technical factors are important, says Kathleen Gaffney, coportfolio manager of Loomis Sayles Bond Fund. Hedge funds, for instance, are taking the risk of borrowing low-cost short-term money and investing in higher yield longer-term bonds.