A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(March 23, 2000) FINANCIAL INSTRUMENTS: In January, the spread between the 30-year Treasury bond and the 10-year Treasury note inverted. The inversion has deepened this year, to levels not seen since the mid-1980's. In the past, an inversion between these two instruments has been an early warning of weaker economic growth.
This chart shows the spread between the 30-year T-bond and the 10-year T-note on the lower line and the yearly change in the coincident indicator on the upper line. Recessions are shown as gray bars. An inverted yield curve has correctly signaled the last three recessions, although the indicator for 1990 recession was somewhat muddled, as the major inversion occurred in late 1988 with smaller inversions into the recession. In nearly every inversion, however, the coincident indicator turned down almost immediately. The only inversion that did not signal a downturn was in 1986, which was probably due to the oil price collapse in that year.
The key issue is trying to decide if the current inversion is correctly, or incorrectly, signaling a downturn in the economy. As a test, we created a model which forecasts the change in coincident indicators using the change in the leading economic indicators and the level of oil prices.
At this point, the model is not signaling an imminent downturn. In 1986, the model's forecast indicated the economy would remain strong despite the yield curve inversion. It is possible the current inversion is more a product of the Treasury buyback than the market factoring in a weaker economy. If so, T-bonds are probably overvalued.
We are long June T-notes/short June T-bonds at 1-14, and would add a position at even, with a protective stop at 16/32's (premium T-bonds) with an objective of 5-00 (premium T-notes).
Bill O'Grady