To buy or not to buy," that is one question. "To extend or not to extend," that is the other question. The explosive rally of the past two months has lowered interest rates all along the yield curve to the lowest levels since the first half of 1983. The yield cure is simply the graphing of the market yield at any one time, of various Treasury maturities from the short three-month T bill out to the 30-year T bond.
During the past two months, the yield on the three-month T bill has fallen 120 basis points (there are 100 basis points in one percentage point), the yield on the two-year T note has fallen 154 basis points, on the five-year T note, a drop of 146 basis points while the yield on the 30-year T bond has declined 92 basis points.
Concurrently, the yields on the high-grade municipal "Bond Buyers Index" fell 90 basis points, while the long-term municipal "Bond Buyers Index" fell 91 basis points.
This raises the two serious questions for investors that introduced this column, because once you penetrate previous low-interest rate levels, technicians or charists perceive sell signals that often reverse market directions. These signals become self-fulfilling and can stop a rally dead in its tracks.
At the same time, with the yield on the three-month T bill having declined more than the yield on the 30-year T bond, the yield spread between these two securities have become much more pronounced or "positive."
On March 18, the spread was 304 basis points, while on May 16, the spread had widened to 370 basis points. In fact, the spreads today are wider between various issues on the T-yield curve than they were two months ago. Put another way, an investor can sell the two-year note and purchase any other issue (three-year, five-year, 10-year) on the curve and pick up more yield than was possible just two months ago.
Therein lies the problem, for the yield curve is extremely steep and should correct. It is unusual for a spread of 370 basis points to exist over a long period of time. So the question to the market becomes, where and when will the curve correct? Will the yields on the longer maturities fall or will it take a combination of both?
Will the yields on the very short-maturities rise?
Although the fundamentals of the marketplace are good -- a weak economy, low inflation and movement on the budget -- sooner or later the low market levels will have to correct. The widest and most attractive spreads between issues always occur just before the market reverses itself.
If extensions are to be made, unless you feel interest rates are going to decline much lower, extend no farther than 10 years. That way, if rates do reverse themselves, your principal loss will be much less than in a 30-year bond. It takes someone with strong convictions to move way out the yield curve at this time in the interest rate cycle.
The Treasury will offer a two-year note on Wednesday in minimum denominations of $5,000. They should return 9.35 percent.