INSIGHTS

On August 23, 2010

Shape Shifting Yield Curves

---

Shape shifting is what the yield curve does best. Those saying the curve is calling for a recession point to the flattening of the curve over the last few months. Those who are calling for an expansion point to the steepness of the curve and very muted inflationary concerns.

The curve has flattened rather dramatically. The Treasury curve as measured from the spread between the 30 year bond and 3 month TBill currently stands at 355 bps, or 3.55%. This is off of the high set on April when the curve’s shape stood at 468 bps or 4.68%. This was in response to the more widely held belief that the economy was rebounding in a more uniform pattern than what we currently see. With the curve flattening by over 100bps, many see the expectations of the overall economy to be in a stagnant recovery at best.

The size of the curve also should be considered. As stated before, the current curve stands at 355 bps. The average over the last 19 years stands at 223 bps or 2.23% which encompasses 3 economic cycles over that time frame. The current measure stands at about 132 bps over the average, which in most circles would constitute a health recovery in the overall economy.

So we are back to the glass half full or glass half empty argument. As is often the case, somewhere in the middle looks to be right. We saw the expansion in risk assets in the first quarter of the year well above what was being represented in the economic metrics compared to the overall deleveraging of the economy. When the markets saw that there were some speed bumps to the recovery, the antithesis became the norm. We now stand where doubts have turned into perception about the economic recovery.

To further put into perspective the volatility that is the yield curve shape, consider the standard deviation of the curve itself which stands at 150 bps, or 1.50% over the last 19 years. Therefore, a spread this wide or narrow, depending upon your view is not necessarily something to alter one’s investment views. It is something one should notice and monitor for further compression or widening. Just like monitoring yield curve inversions, so too should the shape of the curves’ breadth (shape size) and depth (how long it stays at certain spreads) be taken into context.

We continue to see a better case being made for being bullish versus bearish. Though the pendulum which is the yield curve has swung back to a more cautious specter, we would not completely buy into the deflationary or double-dip expectations as we detailed in our most recent Strategic Times.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.