In Too Steep? How to Play the Yield Curve

The bond market "yield curve" -- the difference between long-term and short-term interest rates -- is steep and climbing, typically a sign of a strengthening economy. What's a bond investor to do? Play it safe.

The bond market has been on a wild run over the past few years as shocked equity investors fled to the safety of U.S. Treasurys. The results were record-low yields, a boom in bond prices, and the inevitable talk of a “bond bubble.” In fact, a sell-off in bonds that recently pushed yields on the 10-year Treasury note above 3% for the first time in months may be the forerunner of a bond sell-off, some analysts says.

Wall Street watchers believe a more-useful way to view the bond market is to look at the so-called yield curve, which often sends signals about the direction in which the U.S. economy is headed. A normal yield curve looks like a gentle slope, with lower short-term interest rates rising gradually to higher long-term rates. The logic behind the higher rates on long-term bonds is that investors willing to tie up their cash for 10 years or more deserve a greater reward because they’re taking on more risk.

Back in October 2007, the yield curve was virtually flat, with just a small spread between the yields on short-term and long-term securities. A flat yield curve can often signal a downturn in the economy, according to economists. Although not always on target, the yield curve was right this time around, as the economy and the stock market went into free-fall in 2008. An inverted yield curve, on the other hand, is always a red flag. When bond investors can get a better payoff from short-term securities than by buying long-term bonds, an economic slump or an outright recession ahead is almost a sure bet.

Right now, the yield curve is steep, with the spread between the rate on the 30-year Treasury bond and the 3-month Treasury bill around 4.3%. To the chart watchers, a steep yield curve is a typical signal of an oncoming economic expansion, as long-term bond buyers demand a bigger payout to offset the risk of being locked into lower interest rates when the economy rebounds.

So what’s an individual investor to do? While it’s tempting to unload your bond holdings and pile into riskier securities in anticipation of a stronger economy, it could prove to be a huge mistake.

If the economy is headed for a solid recovery over the next few years, as the steep yield curve suggests, interest rates are likely to climb and investors will bail on bonds and pile back into stocks, ETFs, REITs and other higher-risk securities. If, however, the economy expands too rapidly and inflation heats up, the yield curve may flatten, and bonds, gold and commodities will look attractive once again.

Your best bet as an investor is to take the opportunity now to rebalance your portfolio now to make sure your holdings are well-diversified, so you’re covered regardless of which direction the economy heads.