An interesting adjustment in yield curves may be foretelling the next big move for the stock market. Short term rates are controlled by the Fed. For eight years the Democratic appointed Janet Yellen and the Fed Board have kept interest rates at crises levels of .25 %, or effectively zero. They’ve accomplished this by printing money and floating bonds to pay for government entitlement programs.
This policy created skepticism as large foreign buyers backed away from US debt forcing the US Treasury to buy its own notes and bonds. The Federal Reserve’s balance sheet increased from under $1 trillion to $4.5 trillion over this time. This policy move created winners and losers. The winners were the leveraged buy back Wall Street set, the stock and bond markets, and real estate. The losers were baby oomers and retirees.
Instead of making 6% or 7% which had been an historical norm, bond returns were close to zero. The result was a pesky middle class saver who now couldn’t afford to retire the way it had been intended. To make up that difference boomers were forced to go into riskier investments like stocks and “junk” bonds. This is not an inviting investment scenario, keeping in mind that there are 10,000 baby boomers retiring every day. .
The Fed’s actions over the years have created an interest rate environment where now, short-term rates are being forced higher, but longer-term rates are pressured by foreign investments from Japan and Europe, which find higher yielding US bonds more attractive. Also, with the Consumer Price Index dropping over the last few months, the concern may be fear of deflation rather than inflation over the longer-term. This portends a flatter yield curve.
When the spread between short and long-term rates narrow, the net interest margin for banks narrow and bank profits start to get squeezed. This tends to lean toward less lending and smaller growth for the economy. Worse still is an inverted yield curve which has historically created a recession over a shorter time frame.
Mitch Zacks, of Zacks Investments, points out that the opposite is true in corporate debt. Here the widening of yields between corporate bonds and Treasury/risk free bonds would also be negative for the economy. Corporate leverage is now near a 13-year high. Rising delinquency rates in auto loans, consumer loans and agriculture could help push the widening of this spread. Historically rising delinquencies has been a reliable indicator of an impending recession. At the very least, this should be a recipe for increased volatility.
This divergence of these yield curves is not a common occurrence and bears watching.
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The content of this article is based upon the research and opinions of Tom Reavis.