Over the past couple of months, the stock market has been down, the bond market has been down, unemployment has been down, wages have been stable and interest rates have been rising. How can this be good news? The answer can be found in the improving shape of the yield curve, the progress in the fight against inflation and the transparency in pricing that comes when the Federal Reserve is less involved in the economy.
The term refers to the shape presented when interest rates for US treasuries are mapped out on a graph. The chart would have interest rates along the y axis and the term along the x axis. Of course, common sense tells us that the longer a bond buyer agrees to leave principal invested, the greater potential return he should expect. In other words, the interest rate paid for a six-month term should be less than one paid for a 10-year investment of the same quality. The difference in the yields, shown graphically, is known as the yield curve. Occasionally, interest rates on long term maturities pay LESS than the rate for a short-term US treasury. This is known as an inverted yield curve. This condition tells the Federal Reserve that the bond market believes economic conditions will worsen, perhaps leading to a recession. The economic slowdown would force the Fed to lower short term interest rates to stimulate the economy and the yield curve would return to normal. We have had an inverted yield curve (typically measured by the 2-year US treasury compared to the 10 year) for the past 16 months! *
The inverted yield curve is not only a symptom of an economic slowdown but can also be the cause of one. Banks pay depositors short term interest rates and generally lend money for a longer period. When short term rates are higher than longer term ones, banks have a disincentive to lend. Why pay a depositor a higher rate than you are going to earn when you lend that money out? As a result, bank lending typically slows when the yield curve is inverted. This can be a real problem.
Recent employment data, however, has begun to convince the bond market that a slowdown may not be coming. Interest rates on longer term maturities have increased and the yield curve is beginning to revert to a more normal shape. * This is not a bad thing.
Higher long-term rates will not only encourage banks to lend but will also help the Fed in the fight against inflation, making additional rate hikes less likely. “…long term rates over the past month could slow the economy, effectively substituting for another Fed rate increase if higher borrowing costs are sustained”. ^ The Fed may soon have to shift their focus from fighting inflation, to preventing a recession. The leading economic index declined again last month marking the 18 consecutive decline.#. “Nine of the index’s 10 components showed flat or negative readings…” # This leading economic indicator “anticipates turning points in the business cycle by around seven months.” It is obviously imperfect since the index has been negative for the past 18 months and we’ve had no official recession. The index is worth noting however and tells us that the Fed may have to cut rates sometime next year.
Perhaps the best outcome of the Fed policy of quantitative tightening (shrinking their balance sheet) and higher for longer interest rates is the increased transparency the bond market gets as a result. Beginning with the global financial crisis of 2008 and culminating with the easy money policies during the pandemic, the Fed manipulated the cost of money (interest rates). Without clarity that the market would normally provide, investors were encouraged to increase their risk parameters to earn a return. The recent normalization of interest rates not only provides investors with real choice (vis a vis stocks and bonds) but gives them better clarity of the real cost of money. In fact, I agree with Sara Eisen of CNBC that our current problems are not the result of higher rates today, but rather the artificially lower one’s form years past. “The issue isn’t 5%, it’s 13 years of 0% rates”. **
Addicts will tell you that getting off alcohol is tough. Withdrawal is real and painful. Our financial markets are adjusting to life without the drug of free money, or zero interest rates. Although we all knew the party couldn’t last, it doesn’t make the hangover any less painful.
^Fed Chair Signals Rate-Hike Pause to Stay, Wall Street Journal - October 20, 2023
#Declining Index Points to Economic Slowdown, Wall Street Journal October 20, 2023
** Sara Eisen: CNBC Closing Bell, October 19,2023