Research - The Yield Curve Says Market Goes Up
What is a yield curve and why does an inverting yield curve suggest that the market will return bullish earlier and faster than most people are expecting?
About two weeks ago, the US Federal Reserve (the Fed) started its much anticipated program of increasing the Federal Funds Rate throughout the rest of this year with a 0.25% increase on March 16th from an initial rate of 0.25% to 0.5%. The Fed projects six more rate hikes by the end of the year. Assuming a 0.25% increase each time, we should end the year with the rate at 2%.
Aside: the Federal Funds Rate (Fed funds rate) is the interest rate that the Fed wants commercial banks to charge for lending their money overnight. It’s the shortest of short-term interest rates in the economy and is the root at which all other interest rates are based. Lifting or dropping the Fed funds rate lifts or drops other interest rates in the US economy.
The Fed is engaging in this rate hike program to counter the red hot inflation of the last two quarters. The US inflation rate last month clocked in at 7.9% year-over-year! To put this in perspective, the Fed would like to keep this number at around 2%. By raising the Fed funds rate, the Fed makes it more expensive to borrow money. This slows down bank lending and decreases the overall amount of money circulating in the economy. Less overall money means less spending, which should help pull back inflation.
Increasing the Fed funds rate also has a dampening effect on the stock market. As mentioned above, when the Fed funds rate increases, it also increases other interest rates in the economy, making bond yields more competitive with stock market gains and thus pulling away money from stocks to bonds. In addition, the decrease in the overall money supply from reduced lending also decreases money going into the stock market. This is why the financial media is so obsessed with Fed funds rate increases.
Since the Fed started warning about reeling in inflation with interest rate hikes last year, the stock market has pulled back significantly (SPY dropped from $480 in January to $410 near the end of February). Although the possibility of interest rate hikes didn’t contribute entirely to the fall of the market, it certainly was a major factor. It’s clear that investors are pricing in the possibility of a massive increase in the Fed funds rate by year’s end.
However, could the Fed’s hands be tied, and they won’t be able to increase interest rates as much as they want? If this is the case, then stock market investors have likely priced in too many anticipated rate hikes and the stock market could rebound into a strong bull market earlier and faster than many people expect.
Let’s find out why this could be the case.
What is the Yield Curve?
The US Treasury Yield Curve (yield curve) is essentially a chart of the interest rates of different US debt instruments sold by the US government, with interest rates on the y-axis and maturity dates (i.e. length of the loan) on the x-axis. These debt instruments have different maturity dates and pay interest at different rates. Typically, the further out the maturity date, the higher the interest rate. This is because the longer it takes before a debt needs to be paid back, the riskier the debt is. This also means the yield curve usually slopes upwards.
I’ll refer to these debt instruments collectively as US treasuries, or just treasuries. Treasuries are considered to have the lowest risk of any type of debt in the US economy, since they are backed by the US government. As such, they essentially have rock-bottom interest rates and act as a baseline with which all other interest rates are based.
To tie it back to the above explanation of the Fed funds rate, since this rate is the interest rate of the shortest of short-term debts, it typically acts as the floor of the treasury yield curve and also moves the curve. If the Fed increases the Fed funds rate, the treasury yield curve should increase across the board. The opposite should also hold true. This is why raising the Fed funds rate is often referred to as just “raising interest rates”.
The Yield Curve Versus the Fed
Because longer term treasuries should have higher interest rates, the treasury yield curve typically slopes upwards, as mentioned above. However, this isn’t always the case. Sometimes the market can decide that short-term treasuries should have a higher interest rate than long-term treasuries, for whatever reason, and this creates a yield curve that slopes downwards. Many investors, analysts, and economists consider an inverting yield curve a very credible recession indicator, and for good reason.
Let’s explore why.
There is a common saying that banks make money by “borrowing short and lending long”. This works because, as mentioned above, short-term interest rates are lower than long-term interest rates, so short-term borrowing costs a bank less than what long-term lending makes. When done at high volume, this makes a lot of money. Put into practice, this usually means a bank uses the money from bank accounts to lend out mortgages or issue other long-term debt.
However, borrowing short and lending long only works if the yield curve is sloping upwards. If the yield curve inverts, then this strategy is no longer profitable, as long-term loans bring in less money than the cost of short-term borrowing. As such, banks reduce how much they loan, which reduces the amount of money available in the economy. Why would they do so if they end up losing money? This is the key reason why an inverting yield curve is considered a reliable recession indicator.
And surprise, surprise, the present-day yield curve is threatening to invert at this very moment. The best way to visualize a soon-to-invert yield curve is to look at the difference (i.e. the spread) between the 10-year and 2-year treasury interest rates. Since the 10-year interest rate should be greater than the 2-year interest rate, this spread should be positive. However, we see that it’s been falling aggressively over the last year and is threatening to go negative.
One reason why this is the case is that treasury investors have consistently priced long-term US treasuries at surprisingly low interest rates, likely because they don’t see long-term inflation as a possibility. However, the threat of a 1.75% increase in the Fed funds rate this year places strong upwards pressure on short-term interest rates, thus increasing the interest rate of 2-year treasuries.
The looming threat of an inverting yield curve is why I believe the hands of the Fed are tied. They likely won’t be able to do anywhere close to six more rate hikes by year’s end. Not in their wildest dreams. With the interest rate difference between the 10-year and 2-year treasuries at less than 0.5%, they could probably get away with two or maybe three 0.25% rate hikes this year. If they’re too aggressive, the Fed could trigger a recession that nobody wants.
The implication? The stock market might have been too pessimistic and anticipated more rate hikes than the Fed is able to do, and the Fed is really about to ease off on the brakes to avoid a recession. This could result in the market turning bullish earlier and faster than most people are expecting.
What About Inflation?
Inflation might not be enough for the Fed to keep stepping on the brakes and risking a recession. This is because with the stock market weak and COVID lockdowns having basically ended for much of the Western world, supply chain restrictions and demand for goods have fallen dramatically since last year. Keep in mind that this takes a while to show up in the monthly inflation print. Companies have invested significantly in smoothing out their supply chains (e.g. Walmart chartering their own cargo ships) and people are now shifting their spending away from goods and into services, like traveling.
In addition, much of the ongoing inflation is caused by external factors out of the Fed’s control. The ongoing war in Eastern Europe has greatly increased commodity prices and the Fed funds rate has little to do with these price hikes. The war needs to simmer down or end for these prices to fall. Raising the Fed funds rate by 1.75% won’t end the war.
Finally, there’s precedent of the Fed easing rate hikes, or even cutting rates, during high inflationary periods. For example, in 1969 and 1973, inflation was at about 6% and at both times, the Fed started lowering the Fed funds rate because of a threat of an inverting yield curve.
It appears that the Federal Reserve has historically prioritized avoiding a recession over stymieing inflation.
Fin
If this theory holds true, then it might be a good idea to start dollar-cost averaging into stocks to get ahead of the market’s collective realization that the Fed can’t put its money where its mouth is. Keep a close eye on the yield curve, monthly inflation prints, and the war in the next few months which will gradually give us a better idea of whether this theory has wings (or not). At the very least, it’s beneficial for any investor to keep the possibility of a hands-tied Fed in the back of their mind.
I should give credit where credit is due. This idea was inspired by a video I watched from the Game of Trades YouTube channel. If you want another similar and interesting take on the yield curve situation, check out former hedge manager and current CNBC reporter Ron Isana’s opinion piece published on CNBC.