Deciphering the New Yield Curve

You'd think that would get investors excited. After all, when the yield curve inverted more than two years ago, there was plenty of hand-wringing about the likelihood of imminent recession. But after last week's sharp rise in long-term interest rates pushed 10-year U.S. Treasury rates to 5.166%, and short-term rates remained more than 50 basis points lower, the yield curve now slopes upward at all maturity levels.

This kind of "normal" yield curve is usually just what investors want. It's traditionally a harbinger of steady if unspectacular growth. Bond investors get paid for lending their money for longer periods, which only seems fair. The stock market responded by resuming the rally that had been derailed initially by the steep increase in rates.

The problem is that the conventional wisdom about yield curves and the economy has been stood on its head in recent years, and no one has yet offered a convincing explanation why. The inverted yield curve did not result in a recession, or anything close to it. On the contrary, global economic growth has been so strong that the biggest worry in the credit markets remains inflation. Indeed, it was inflation fears that sparked last week's interest rate spike, as best anyone can tell.

No less an authority than former Federal Reserve chairman Alan Greenspan called the recent inverted yield curve a "conundrum." That's because the Fed's campaign to raise short-term rates led to lower, rather than higher, long-term rates. Do we now have the makings of a new conundrum, higher long-term rates that remain so in the face of slower growth or even Fed cuts? Time will tell, but after the last few years, nothing would surprise me.

I don't think investors should underestimate the significance of a sustained rise in long-term rates to an economy that has become gorged on easy credit. Financial institutions are likely to bear the brunt, especially those which have cashed in on the mergers and acquisitions and private-equity booms, both heavily dependent on low rates and easy borrowing conditions. That's one reason I sold covered calls recently against my position in Goldman Sachs (GS), which last week reported some modest tremors from the subprime lending meltdown, as did Bear Stearns (BSC).

Sooner or later higher borrowing costs are also going to impact consumers. How they're going to keep paying their gasoline and heating bills while adapting to a wave of adjustable rate mortgage increases remains to be seen, but I'm wary of consumer sectors, especially retail.

For fixed-income investors, it's still an easy call: two-to-five-year certificates of deposit. As readers of this column know, I've been positioned for higher long-term rates for years, advocating a ladder of two-to-three-year maturities. The recent increase in rates has had almost no impact on their value given their short duration and relatively high yields. I have a CD maturing this week, and I plan to roll it over into another three-year CD. The good news is that CD rates keep creeping higher. When I recently checked, six-month CDs were yielding 4.64% to nearly 5% for five-year CDs. Not bad for low-risk federally insured deposits, especially when other asset classes look overvalued.