Yields Discourage Long-Term Investing Flat Curve Makes Treasury Bills, Money Market Funds Less Risky Than Bonds

The yield curve is flattening, the yield curve is flattening!

The words may not exactly resound through the town squares of America. But they tell one of the big, legitimate financial news stories of early 1995.

Certainly, it’s a noteworthy development for anyone who is planning to lend or borrow money, to buy on credit or invest.

Consider that, on one recent Wall Street morning, Treasury bills of threemonth maturity were yielding 5.88 percent while yields on 30-year Treasury bonds stood at 6.87 percent.

Thus, the spread between yields at the two extremes of the maturity spectrum of securities issued by the federal government was less than 1 percentage point. Just five months earlier, at the end of 1994, the differential was 2 percentage points, or 225 basis points. In early 1994, it was wider than 300 basis points.

If you plot the range of yields on a graph, last year’s figures trace a steeply sloping line. By now, this “yield curve” has turned almost horizontal.

What this means for the investment and economic outlook is clear in some cases, and open to debate in others.

On one point at least, there is little debate: Current conditions offer much less visible incentive for savers to take the risk of buying long-term, rather than short-term, interest-bearing investments.

The yield curve has flattened because yields on long-term securities, such as bonds, have fallen sharply in the last six months, while short-term money market rates have come down only slightly.

In the eyes of many economists, the drop in long-term rates signals that fears of a revival of inflation have ebbed significantly.

The Federal Reserve, which exerts a strong influence on short-term rates, has stopped tightening credit conditions to forestall inflation. But it hasn’t yet made any move to nudge money rates lower again.

If the yield curve keeps flattening, it would have widespread effects on the cost of money. For instance, it would tend to narrow the interest-rate advantage that adjustable-rate mortgages, which are typically pegged to one-year securities, enjoy over fixed-rate mortgages.

It would also increase the apparent attractions of short-term vehicles such as money-market funds in comparison to long-term investments such as bond funds.

At times in the past, however, yield curves that are flat or inverted (when short rates actually exceed long rates) have pulled a fast one on many investors.

In the early days of the 1980s, for instance, savers had a chance to lock up yields on bonds and long-term bank certificates of deposit that were well into double digits.

But at the interest rate peak, moneymarket yields were even higher, in the 15 percent to 18 percent range, persuading many investors to stay short. They missed a golden opportunity.

In theory, a “normal” yield curve should have at least a moderate slope, rewarding bond buyers for taking greater time risk than money-market investors must face.

Thus, quite a few analysts regard flat to inverted yield curves as evidence that something isn’t quite right with the economy. “The yield curve has flattened to the point where it could be negative for stocks and bonds,” says financial adviser Martin Zweig in his current Zweig Forecast letter.

But the script could play out differently if the current flattening foreshadows any action by the Fed to ease credit conditions. Should that happen, “individuals who have been quite comfortable sitting in money-market fund or CD rates that are adequate for their needs (near 5 percent-6 percent) will start to worry,” says Greg Smith, investment strategist at Prudential Securities.

“Short-term rates, and therefore the returns on money-market funds and CDs, will fall and cause individuals to shift into longer-term financial assets.” That would supply fresh fuel to the bull market in stocks and bonds.