Polymorphously Inverse

January 4, 2006

Dear Investor:

The yield curve inverted recently, with the 2-yr rate rising a basis point or two above the 10-yr. Often, a yield inversion predicts recession. Clearly, something is up: If people are willing to lend money for the same amount for both two years and ten years, they certainly don’t expect inflation. They probably expect deflation, or at least disinflation—a slowdown in the rate of inflation and a common characteristic of recession.

It wouldn’t be surprising to have a recession after so many quarters of strong GDP growth north of 3%. In classic cyclical terms, we’re due for one. This would also be expected as the massive monetary and fiscal reflation of the past three years simmers down. But if the yield curve inversion is followed by recession, this will be coincidence, not prediction. This inversion has many components, but only one of them is disinflationary.

If we look closely at the yield curve, we see it is less inverted than “sagging,” with 5-yr and 10-yr rates less than both 2-yr and 30-yr rates. In addition, the 3-mo and 6-mo rates remain below the 2-yr. This is far from a classic inversion and more of an isolated stretch of yield distortion which runs through the sagging middle—along the 5-10 yr range. If investors expected classic deflation, they would bid the yield curve into classic inversion, with 3-mo rates above 10-yr rates and, perhaps, even above 30-yr rates. Instead the curve sags with the weight of its own albatross, along the center of the curve.

We would argue that this distortion is caused more by Chinese buying of our Treasury bonds, without ordinary concerns of price and risk, in order to peg their currency (see our comments in The Motley Fool last week). We’ve written in the past how these artificially low yields were causing the housing bubble by perpetuating access to cheap money. Interestingly, as China finally began to loosen the peg a few months ago (and hence slowed their purchases of our bonds), long rates crept up and the housing market started to sputter. Today, the housing market is indeed running into serious trouble, with inventories of unsold homes at a 19-yr high and declines in many overpriced markets.

That the yield curve is distorted in the middle is more evidence for this China effect, since such buying is concentrated along the middle and has the most price effect in that range. Again, it points to a buyer purchasing without regard to price and risk—the China effect. A rational approach to deflationary hedging would instead invert the curve normally.

There is no doubt in our mind that the yield curve is thus operating at many levels, reacting to slowing inflation but also to the China effect. It’s truly a polymorphous inversion, with many perverse repercussions.

Inflation is, in fact, slowing. This is mostly a result of the Fed’s effective tightening cycle—a final accomplishment to solidify Greenspan’s extraordinary legacy. This is good news for equity investors, since a modest inflation rate and current reasonable valuations form a fertile atmosphere for stock appreciation. We are thus overweighting equity allocations. Even Japanese equities, which appreciated over 20% in the past few months, still look reasonably priced. We also continue to keep bond duration very low. Now that the Fed has almost finished raising rates, the short end of the curve looks attractive while anything beyond five years courts major risk. Especially as China continues to loosen the dollar peg, long-term yields should trend upwards.

A final note: the Euro, at $1.20 finally looks like a good buy again versus the dollar, especially as U.S. short-term yields plateau. Much of the impressive strengthening in the dollar last year was due to rising short term rates. We are looking to further overweight foreign sovereign bond positions (through the John Hancock Strategic Income Fund and the Loomis Sayles Bond Fund) in anticipation.