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The troubling mystery of the 'yield curve'

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For those who follow bonds, it's a mystery as engrossing as a Sue Grafton novel: How can long-term interest rates fall when the Federal Reserve is pumping up short-term rates?

That's not supposed to happen. In theory, investors should get a bigger return for taking the extra risk of tying up their money for a longer period. That's especially true when inflation is rising, oil prices have soared, and the economy has been growing.

This narrowing of the gap between short- and long-term rates is called a flattening of the yield curve. And it's a concern. If short-term rates actually exceed their long-term cousins, then wild and potentially harmful things can happen to the stock market and economy.

So why are rates falling on long-term United States Treasury bonds?

It's a "conundrum," states Stephen Roach, chief economist at Morgan Stanley, a major investment bank.

Even Alan Greenspan, chairman of the Federal Reserve, is scratching his head. It's "clearly without recent precedent," he said a week ago.

Here's where we stand: The Fed controls short-term rates, specifically the Federal Funds rate. Since last June, it has pushed up its interest rate eight times, from 1 percent to 3 percent. Another hike is expected when Fed policymakers meet later this month. In the same 12 months, however, yields on 10-year Treasury bonds have fallen about 0.8 percentage points to 3.94 percent. Yields on corporate bonds fell even more.

That's a narrow margin by historical standards - but not unprecedented. Several times in the past, long-term bonds have actually yielded less than short-term notes.

The last time it happened - in early 2000 - it presaged the bursting of the dotcom bubble and the subsequent recession in the US.

But that's "not a hard and fast rule," cautions Brian Reynolds, chief market strategist for M.S. Howells & Co., an investment boutique in Scottsdale, Ariz., serving more than a hundred hedge funds. The yield curve reversed in the last week of 1994, and stock prices surged gloriously for three years.

And though long-term rates have dipped faster in the past year than in many decades, he notes, Mr. Greenspan didn't predict a slump, nor budge from the Fed policy of raising interest rates at "a measured pace" in the months ahead.

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