Friday, September 3, 2010

The Yield Curve is Steepening.

I warned in a previous  blog that people who were extending their maturities in order to get a higher yield may be in store for some loss of principal as interest rates rebound. I used the rebound instead of rise for a specific reason. The yield on the 10-year T-Bond has come down dramatically, at one point the yield was 2.42% intraday. As of this publishing the yield on the 10-year is now 2.70% or up 30 basis points from its most recent low. Some forecasters think we could go back to 3% yield on the 10-year.    

Recently I published a note from Merrill Lynch that was projecting the yield on the 10-year at year end to be around 2.5% which was lowered from their previous target of 3.25%. The Investment Company Institute (ICI) reports that for the year a significantly greater amount of money is flowing into bond funds vs. common stock funds.    

As people have moved out of low yielding cash money market mutual funds and into bonds they are taking more credit and duration risk with their money. The credit risk is not knowing for sure that the company issuing the IOU will be able to make the interest and principal payment. The duration risk is the longer term you invest your money the more it can fluctuate on a day-to-day basis with market conditions. If you had to sell you may or may not get what you paid for the investment.  

I still believe that we will be in a Japan-type of recovery until we can make significant improvement in the jobs area. High unemployment and depressed housing will keep the breaks on the US economy for years to come. Interest rates will fluctuate but I still think the bias is for rates to continue to fall. The declines in interest rates will be slow and somewhat volatile,   

While longer term interest rates are moving higher, shorter-term interest rates are falling again. Over the last three months 90-day LIBOR has declines from 54 basis points to 29 basis points. The downward movement in 30-day LIBOR is less dramatic but 30-day LIBOR interest rates have fallen from 35 basis points to 29 basis points.   

On the Treasury side 90-day T-Bills have fallen from 19 basis points to 12 basis points over the same period. So, we have a steeping of the yield curve in that short interest rates are falling while long-term interest rates are rising.   I have been thinking again and some may say, don’t hurt yourself. I have been thinking about the sacred prime interest rate. The prime rate is the benchmark for many different financial products, like credit cards, mortgages and business loans. The prime rate has not moved in almost 2 years so what would have to happen to break the back on the prime rate?   

People have different opinions on the outlook for the economy and some feel that the Fed will be forced into some type of Quantitative Easing later this year after the election. It would not surprise me that the new office of Consumer Protection starts talking up a reduction in the prime rate. Remember you heard it hear first, the idea that deleveraging of the balance sheet of the consumer and small business need to get the same interest rate benefit of big business, that of a lower cost of funds.   

Dan Perkins          

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