A few of you have reached out to me regarding the bond market article in our last QTLY Newsletter and have asked questions about what is going on in the bond space. Therefore, this market update will address short term and long term interest rates, the yield curve and how that relates to the stock market.
Short term rates (2 year bond yields) have been rising at a faster pace than long term rates (10 year bond yields) in response to the Fed’s tightening bias (they are raising rates to slow things down to avoid inflation). However, if they move to fast they will cause a recession. Once the short rates exceed long rates it produces a condition referred to as an “inverted yield curve”. An inverted yield curve is one of the more reliable precursors of a recession. The Treasury Yield Curve inverted before the recessions of 2000, 1991 and 1981 and two years prior to the 2008 financial crisis meltdown.
For this reason, observant stock market investors are watching this development in the bond market and the implications could be cause for concern. In a warning sign for the stock market, the spread between the 2-year and 10-year bond yields is down just 43 basis point (about 4/10th of a percent), its lowest since 2007, as of last week (5/18) Friday.
Again, a flat or inverted yield curve, in which yields on bonds with a shorter duration are equal to or higher than yields on bonds with higher or longer durations, generally means that investors are losing confidence in the strength of the economy. When there is little difference in the yields of short and long-duration bonds, pressure mounts on the financial sector where the business mantra “Borrow Short and Lend Long” spells trouble when there is little, no or even negative difference between “Short” and “Long” rates.
For now, there is some room for the short rates to climb before the alarm bells fully start to ring. Nevertheless, the yield curve has flattened and has been close to inverting at key points. We will continue to monitor this development closely. Please refer back to our Second Quarter 2018, Quarterly Market Update, Understanding Bond Markets article to see how much of a negative impact just a small 1% increase in the yield curve has on 10 year notes and 30 year bonds. It is truly devastating to the value of your dollars invested in these buy and hold bond investments. Which is another reason why we are tactical, flexible and willing and able to adjust accordingly.