The idea of using the yield curve to forecast the future of the economy is nothing new, not to mutual fund managers anyway and particularly not for people who are interested in, investing in or working for bond funds. It is an essential ingredient to cooking up the right investment management strategy for the quarter and year to come. But what can the yield curve tell people about other types of mutual funds, like growth funds, dividend funds and, gasp, small cap funds?

The idea that the yield curve is relevant only to bond investors is silly.

In fact, the yield curve can tell investors a lot. At the Mutual Fund Site, we believe that the Yield Curve can help confirm or refute areas of perceived value. And small cap mutual funds are potentially one area of great value. Why? Because even after a strong equity market that showed tremendous leaps of recovery in 2009, small cap shares remain somewhat unattractive. In fact, the average small cap growth fund will have returned -7.29% over a 3-year period as of February 11, 2010, while the average large cap growth fund returned -5.29 over the same period. The same story is told in the small cap blended and large cap blended categories according to Morningstar.com, but when looking at straight value plays, the opposite is true: small cap value funds have performed better than their large cap counterpart.

At any rate, what does the yield curve tell investors?

According to the definitions provided by Smart Money, the normal spread between 3-month Treasury Bills and 30-year Treasury Bonds is 3%. When the spread is greater than that, investors are signaling that they believe that the economy will improve quickly in the future. Long term investors become nervous that they will stay locked in at currently low rates (sounds familiar) and demand higher returns on their capital. According to the traditional definition, the yield curve is currently steep, as demonstrated by data available at Bloomberg.com.

How does a steep yield curve help small cap companies?

Well, small cap funds historically perform very well after a recession. That is because larger companies as well as retail consumers are more willing to try out the small guy. They can “afford” to experiment a bit. This could mean buying a home from a small-cap builder, using technologies developed by a small-cap company and so on, whereas in the past they have kept a close eye on their budgets and stuck to well-known, established providers who might have even undercut their small-cap competitors.

Additionally, as the economy improves, large cap companies that have been able to finance their survival through the recession may find themselves paying more for the money they borrow, particularly if they borrow on floating rates such as LIBOR or some derivative thereof. Small cap companies in comparison have been shut out of the credit system as lenders and capital sources became increasingly nervous about where they lent their money. So while larger companies juggle higher debt payments smaller companies will not have as much debt to worry about, resulting in lower debt/equity ratios which in turn means stronger financial statements.

Lastly, based on the above, small cap companies stand to enjoy grater profit margins. With less overhead, less debt, and more money flowing into their companies, small caps will seem “stronger” financially than their large-cap counterparts. Of course, this depends on the measures being used but with stronger profit margins and a conservative fiscal policy, small caps will be able to retain those earnings and build their equity base quicker (in percentage terms anyway).

The Yield Curve tells us this. It tells us that since December 2008, the outlook on the economy has been steadily improving to the point where it is at today (February 11, 2010) with the spread between 3-months Treasury Bills and 30-year Treasury Bonds greater than 3% (it is at 4.57% in fact). And the trend suggests this spread will only widen, meaning that small cap mutual funds a touch more attractive right now than their growth fund counterparts.

Note: we recommend that you speak with your financial adviser before investing in higher risk mutual funds such as small cap funds.