NEW YORK (CNN/Money) -
A flattening yield curve sends a message to investors: Get defensive.
The graph of bond yields in the Treasury market usually slopes upward, with yields on longer-term bonds higher than shorter maturities to compensate investors for taking on the additional risks of a longer-term investment.
But the long-term yield has not been rising, even though Federal Reserve policy-makers have raised a key, short-term interest rate, the fed funds overnight bank lending rate, to 3.25 percent from 1 percent just over a year ago. (Full story.)
Some experts even say there's a decent chance the curve may soon invert. (Confused about yield curves? Click here for help.)
While the jury is still out over whether an inversion portends recession, investors should consider the curve now. But when and how to act depends on how fast the curve flattens or inverts and what factors accompany the trend.
And with second-quarter earnings growth expected to be the slowest in three years, investors should be especially choosy. (Full story.)
If the curve flattens gradually, most traders said it probably means investors believe the Fed will keep future inflation in check with gradual rate hikes. Bond traders hate inflation because it erodes the value of their fixed-income investment.
But if the curve-flattening trend speeds up?
"It's time to trade out of investments whose success depends on a strong economy... for both stocks and corporate bonds," said Anthony Crescenzi, chief bond market strategist at Miller, Tabak & Co., an institutional brokerage.
This means reducing exposure to sectors like retail, transportation and automobiles and moving into defensive picks like health care and consumer goods.
But how does the market gauge whether the curve is flattening fast or slow?
Crescenzi said that over the last two years, the spread between the two-year note and the benchmark 10-year bond has shrunk by about 10 basis points per month. (100 basis points = one percentage point.)
But over the last year, the spread has diminished by 15 basis points a month, a faster pace that raised some eyebrows and sparked yield-inversion speculation. But, Crescenzi said, this seems reasonable since it is pretty much coincident with the Fed's rate hike campaign.
"It is when the pace becomes much faster than 15 basis points a month that investors should start to worry," he said.
Context is everything
If the yield curve flattens faster or inverts, investors need to be aware of what's going on outside the bond market to react well, fund managers said.
For example, if yields invert concurrent with soft economic releases, then it's time to consider a defensive investment strategy.
But there are some scenarios that aren't as troubling for investors, said Steve Rodosky, vice president at Pacific Investment Management Co. (PIMCO), one of the world's biggest bond investors.
For example, Rodosky said the yield on the 10-year could even fall below that on the two-year if the pension community snaps up bonds because it decides it needs assets.
Nevertheless, "investors should think about being more risk averse going into the latter half of the year," Rodosky said.
"We think the bigger story for the second half of the year will be a significant rotation into the more defensive sectors of the stock market, and that these sectors become consensus favorites by the end of the year," Merrill Lynch said in a recent research note.
While Rodosky was one of the few who said the Fed would begin to reduce rates should a yield curve inversion occur, most analysts said investors would likely sell, and that would eventually correct an inversion.
"The flat yield curve shows investors aren't being compensated for taking extra maturity risk," said Rodosky, adding that the natural response would be to sell their long-term government bonds and buy shorter-dated debt.
Does the flattening curve reflect a weakening Federal Reserve? Click here.
To find out why Cantor Fitzgerald predicted an inverted curve, click here.
To read why Cantor said the curve may not happen, click here.
For more on the yield curve, click here.
To see what bonds are doing today, click here.