“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
- James Carville, Political Pundit Wall Street Journal (February 25, 1993, p. A1)
There is a lot of talk right now on the strength of the bond market, the yield curve, the slope of it, the shape of it, its use as a forecasting tool, and how the current shape of it may impact the stock market.
Before we dive in, it is helpful to define what it is we are talking about. The yield curve everyone is talking about is a plotting of interest rates for US Treasuries with the time to maturity on the X-axis and the yield to maturity on the Y-axis.
The graph below illustrates the yield curve as it stands today,5/30/2019, in green and where it was 1 year ago, 5/30/2018 in blue.
Source: Ycharts
Last year’s curve was considered normal, rates were higher the further out in time all the way out the curve. Today’s curve is driving prognosticators bananas, because it is inverted at the very front end. This means that short term rates are higher than longer term rates. What does that mean in practice?
It means the market is predicting that future short-term interest rates will be lower than today. The reason why and the implications of that are the subject of debate.
One hypothesis is that the inverted curve is predictive, or indicative of a slowing economy and the Fed will need to cut rates in response. A competing hypothesis is the inverted curve disrupts the money markets and creates an environment that leaves the economy vulnerable to setbacks.
The first view is fairly deterministic and a little fatalistic,the second view recognizes that the market is a complex adaptive system and sensitive to changes in key inputs. Put us in the second, competing hypothesis camp.
Our view is that short term interest rates today are higher than if the Fed chose not to set them, it is hard to say exactly how much higher, maybe as much as 0.50-0.75%. We’ve thought this since the end of last year and said as much in our year-end client letter, email us if you would like a copy. Right now, monetary policy could be considered contractionary but that, in and of itself, may not break the economy. The Fed has greatest control over the short end of the yield curve and their effect is dampened the farther out the curve you look. The market wants rate cuts and has priced the rest of the curve accordingly, possibly creating the conditions where a setback could occur if the Fed waits too long to act and doesn’t do something preemptive.
Markets sold off in December of 2018 when the Fed Chair Jerome Powell made comments that seemed out of touch with the market on rate hikes for 2019. In response, Fed officials backed off those remarks and markets recovered. In our view the market learned that this is a Fed that can be pushed around, so it isn’t surprising to us that we now have an environment where preemptive rate cuts may be necessary.
Right now, the market for Fed Funds futures is pricing in rate cuts of 0.50-0.75% by year end. It is worth noting if there were preemptive rate cuts in this ballpark the yield curve would "un-invert" and they might actually help it steepen a bit further. In our view the part of the curve that is creating the conditions for a setback can be changed, whether or not that happens remains to be seen but the Fed Funds futures market seems to be betting on it.
