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Irwin Kellner

Take the fork...please

Commentary: Bond market can't make up its mind

HEMPSTEAD, N.Y. (MarketWatch) -- The bond market seems to be following the words of that great economist, Yogi Berra, who once said: "when you come to a fork in the road -- take it."

Since the beginning of this year, one message from the bond crowd has seemingly been loud and clear: a slowdown is coming and it will lead to lower interest rates across the board. Why else would the yield curve (the term structure of interest rates) have flattened so that yields on the two-year Treasury note equaled and at times exceeded the yield on the ten-year note?

This is quite a change from the situation in the middle of 2003. That's when the ten-year note yielded about 250 basis points (2-1/2 percentage points) more than the two-year note. Then again, the economic outlook is a lot different today than it was three years ago: then it was rosy, now it's gloomy.

Indeed, this flattening of the yield curve, itself, has many prognosticators worried. This is because such a development has preceded each of the recessions we've experienced since 1980, making it a fairly reliable leading indicator.

But the bond market is sending out another message as well. This message is not as obvious as the one broadcast by the yield curve. However, it's important, nevertheless, because it deals with something near and dear to the heart of bond folks and that's inflation.

To safeguard bond buyers against the eroding effects inflation can have on their portfolios, the Treasury back in 1997 began issuing a security whose yield adjusts for the change in prices. These Treasury Inflation Protected Securities (otherwise known as TIPS) carry a lower interest rate than their regular counterparts, but it's made up for by the inflation adjustment.

Economists soon discovered that if they compared the yield on these TIPS with the plain-vanilla instruments, they had a pretty good idea of the bond market's thinking when it came to inflation expectations. This became even more important as yields on the ten-year note began to drift perilously close to the rate of inflation, instead of hovering their usual three points above. See August 1 column.

When bond buyers worry about inflation, they rush to buy TIPS, rather than the regular Treasuries. This drives up their price and pushes down their yield -- both in absolute terms and when compared with the yield on the plain-vanilla note. The bigger this spread, the more bond buyers are worried about inflation.

Guess what? From 2.3 percentage points at the start of this year, the spread between the regular ten-year note and the ten-year TIPS has widened steadily, reaching 2.7 points at the start of this week. That's one of the biggest spreads since early 1998. It parallels the steady pickup in the core rate of inflation, from 2% earlier this year, to almost 2.4% today.

By signaling both a slowdown and a pickup in inflation, the bond market could be trying to have it both ways. Or, it could be looking for the combination of these two trends, stagflation, as I opined back on Aug. 8. See earlier column.

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