Looking at the Treasury yield curve provides a good idea of the economic and market forces at work recently. The curve is a snapshot of the bond market, charting yields of different maturities.
Generally, yields on long-term bonds are higher than those on short-term bonds, simply because it costs more to borrow money for a long time than for a short time. But various things can change that.
Recently, two major forces have been at work on the curve: the slowing economy and the fear of inflation due to rising oil prices.
The Federal Reserve affects interest rates by raising and lowering the federal funds rate, the interest banks pay on overnight loans.
When inflation looms, the Fed generally tightens credit, which forces short-term rates higher. When short-term rates outstrip long-term rates, the yield curve is said to be inverted, or negative.
Inflation, or at least the fear of inflation, is the bane of the longer maturities because it erodes fixed-coupon income. The long end of the market sells off because investors want a higher return to adjust for inflation.
With the economy slowing you would expect the Federal Reserve to ease credit. When the Fed lowers interest rates, it usually affects bonds of all maturities. The yield curve goes back to its normal, or positive, state.
The usual manner of analyzing a yield curve is to look at the yield spread between the two-year note and the 30-year bond.
This spring, the yield curve was slightly inverted to just about flat. On July 6, the spread was +18: That is, the 30-year bond returned 18 basis points, or 0.18 percent, more than the two-year note. By July 27, the curve had grown more positive, +50 basis points, as the weak economy led the Federal Reserve to lower the federal funds rate a quarter point to 8 percent.
During August, as the market wrestled with the slowing economy and fear of inflation, the yield on the 30-year bond jumped from 8.50 percent to 9.17 percent on Aug. 24, and the spread widened to +89 basis points, or 0.89 percent.
In all likelihood the Fed will ease again, but the fluctuating price of oil will keep the long bond in the vicinity of 9 percent. In this situation, the curve will become even more positive.