The Shape of Things to Come

{Q} Does the Federal Reserve Board watch the yield curve?

{A} Yes, it does. As a matter of fact, there was a recent study published by the Federal Reserve Bank of New York, and they, too, found that the yield curve is a very good indicator of future economic slowdown. Its predictive value tends to be very good especially in predicting a recession.

{Q} So, is this an argument that people shouldn’t invest in short-term bonds, but rather think about investing in long-term bonds?

{A} Yes. The novice will ask, ‘Where can I get the highest yield?’ Today, that’s in short-term securities. But a professional will look at the curve configuration and say, ‘I may invest in five-year bonds because I’m fairly convinced that a year from today, interest rates will be significantly lower. By investing in five-year bonds, I have locked in that yield for the next five years, and I won’t have to take the reinvestment rate that’s available when my short-term security matures.’

{Q} What are some of the tangible consequences of what the yield curve is telling you?

{A} It’s telling me the economy is slowing and that in 2007 you’ll see the Fed lowering, not raising interest rates. I think we’ll see a continuation of the slowdown in the housing market. We’ve already seen a fairly dramatic decline in the rate of job growth. Those factors don’t predict that good of an economy, frankly.

{Q} From your perspective, What’s going on in the mortgage-backed securities market?

{A} The dynamics of the mortgage-backed market are so much different today than they were five years ago. For example, today roughly 80 percent of mortgages issued have an interest rate below 6 percent. So to get a large percentage of mortgage-backed securities to refinance, long-term interest rates have to come down quite a bit from where they are today.

{Q} So would you say that the mortgage-backed securities market is much more stable now?

{A} Yes. Today I can buy a mortgage-backed security and I know that today, all the mortgages that back that bond have an interest rate of 5 percent. If the current mortgage rates are 6 percent, people have no financial incentive to refinance their mortgages; therefore, prepayments in those packages of loans will not accelerate—resulting in a premature return of capital—so I won’t be getting money back when I don’t want it.

{Q} What’s going on with other types of bonds?

{A} When I look at corporate bonds, I demand additional yield because corporate bonds carry more risk than a government-issued bond. When compared on a historical basis, corporate bonds today are giving the investor a much lower-than-average spread, or additional yield for the additional risk. In other words, you’re not being compensated for the risk you’re taking. It’s not a good bet today.

{Q} Normally, a mortgage-backed security pay a decent interest rate over and above conventional treasuries. Do you think that they are a good deal right now?

{A} I think they’re a fairly good deal. For example, on a 20-year mortgage-backed security right now, you’re getting a full percentage point over a like-term treasury. And historically, that’s pretty good.