Crescenzi, The Strategic Bond Investor

Anthony Crescenzi, senior vice president, market strategist, and portfolio manager at PIMCO, is no mole. He doesn’t divulge the firm’s secrets in The Strategic Bond Investor: Strategies and Tools to Unlock the Power of the Bond Market (McGraw-Hill, 2010). This revised and expanded second edition of the 2002 edition reads more like a textbook than a battle plan.

Textbooks are, of course, important educational tools, and were I to teach an elementary course on bonds (perish the thought!) I might seriously consider The Strategic Bond Investor. First of all, I was familiar with almost all of the material covered in the book—and I am decidedly no bond guru. Second, it is well organized and easy to read.

In this post I’ll follow Crescenzi in looking a little more closely at the Treasury yield curve, “the bond market’s crystal ball.” Yield curve graphs commonly include T-bills with maturities of 3, 6, and 12 months; 2, 3, 5, and 10-year notes; and 30-year bonds. The shape of the yield curve serves as an effective barometer of the U.S. economy. The normal yield curve is positively sloped, with short-term interest rates lower than long-term interest rates. An inverted yield curve, where short-term interest rates are higher than long-term rates, portends ill for the economy (as well as stocks and bonds). “In fact,” Crescenzi writes, “since 1970 every inverted yield curve has been followed by a period in which the S&P 500 earnings growth was negative, and it has almost always preceded either an economic slowdown or a recession.” (p. 177)

The yield curve can see farther into the future than the stock market: “the yield curve predicts economic events roughly 12 months or more in advance, while the stock market is thought to foretell events only 6 to 9 months in advance.” (p. 178) It has outperformed the Conference Board’s index of leading economic indicators, which “sent several incorrect signals in the 1982 to 1990 boom period,” and has either matched or outperformed a set of professional forecasting services.

Crescenzi urges the reader to heed the yield curve even as its detractors claim that “this time is different.” In January 2000 when the curve inverted for the first time since the recession of 1990 and 1991 the naysayers argued that the inversion was merely technical, related to the U.S. buyback of national debt. In 2006 China’s recycling of dollars was the rationale. But, Crescenzi maintains, “ultimately fundamental influences drive long-term rates.” (p. 181)

The yield curve’s fortunetelling skills can be fine-tuned by analyzing the magnitude of the inversion. One of the most powerful models for predicting recession four quarters out is the yield curve spread between the 10-year Treasury note and the 3-month T-bill. The results of a Federal Reserve study (Estrella and Mishkin) covering the period 1960 to 1995 link the value of the spread in percentage points to the probability of recession. A positive spread (with values ranging from 1.21 to 0.02) links to probabilities of 5% to 25%. Once the spread turns negative, probabilities go from 30% at a -0.17 reading to 70% at -1.46, 80% at -1.85, and 90% at -2.40.

Crescenzi outlines ten factors that affect the shape of the yield curve—monetary policy (the most influential), economic growth, fiscal policy, inflation expectations, the U.S. dollar, flight to quality, credit quality, competition for capital, treasury supply, and portfolio shifts. The savvy market maven will sort through these factors, trying to separate out the technical from the fundamental. The average Joe will probably do just as well by taking the yield curve at face value.