Inflation pressures have stabilized, if not moderated somewhat. The Fed has not tightened since last December. The UST yield curve has flattened since the beginning of the year. In fact, the benchmark 2-year to 10-year UST curve now stands at 78 basis points. This is down from 121 basis points at the beginning of 2016 and 149 basis points this time last year.

The mean reversionists point out that a benchmark curve of 78 basis points is the flattest since November 2007, the time when the U.S. economy fell into recession. The curve was steepening at that time as the Fed was already easing, trying to halt the economy’s slide. I believe today’s conditions better resemble the previous time the benchmark UST curve was at 78 basis points.

Benchmark 2-year to 10-year UST curve since 2004, lower value equals flatter curve (Bloomberg): 

In early February 2005, the benchmark 2-year to 10-year UST curve was at 78 basis points. As with today, the economy was in expansion mode and the yield curve was in the middle of a long-term flattening regime. In February 2005, the U.S. economy had nearly three more years of expansion ahead. One could make the case for several more years of (albeit moderate) economic expansion today. I am not a believer in blind adherence to mean reversion, but conditions surrounding the flattening are similar.

Wait you say; the Fed was well into a tightening cycle by February 2005. It has only tightened once (25 basis points) this time. Not so fast. Look at the shape of the yield curve since December 2013. What happened in December 2013? The Fed began tapering asset purchases. Although the Fed went to great lengths to stress that tapering was not tightening, the bond market disagrees. If asset purchases amount to quantitaive easing, then tapering must, at least, be considered quantitaive renormalization, if not quantitative tightening. This is similar to interest rate renormalization/tightening in the days before QE. It is my opinion that we are several years into a policy tightening regime as monetary stimulus was scaled down over that time.

The idea that a flat yield curve augurs for a recession is popular in the weath management industry. However, when the yield curve goes dead flat or inverts, a recession can still be a year or more away. In fact (as the above chart indicates) the yield curve is often quite steep when the economy enters recession, as the Fed scrambles to reinvigorate a slowing economy.Theoretically,the Fed (or any central bank, for that matter) might be able to avert a recession, if it acted quickly enough after the curve flattens. It might be fairer to say that a flatter yield curve indicates that monetary policy is becoming restrictive and anti-inflationary. However, central banks tend to be reactive rather thanproactive. Thus, they tend to be behind the policy curve, time after time.

In my opinion, considering that tapering amounted to quantitative tightening (deceleration is acceleration in the opposite direction), the Fed has probably fewer (perhaps far fewer) rate increases left to be done than many strategists, economists or Fed officials believe. This does not necessarily mean the Fed will not or should not tighten. My personal opinion is that the U.S. economy is sufficiently strong to warrant monetary policy renormalization. However, given the evidence that tapering was akin to tightening, the Fed probably does not have to raise the Fed Funds Rate very much or very quickly.

Last week, an idea surfaced in the markets, particularly among the punditry, that the stock market sees something the bond market does not. This thesis is based on the fact that long-term U.S. Treasury yields have remained range-bound between 1.50% and 1.59% during the month of August, while bond-like equities (dividend stocks such as utilities, consumer staples and telecoms) have begun to sell-off. I believe it is the stock market that is misreading conditions, or more accurately, investment models are misreading conditions.

Note: I would not lump in some telecom companies, such as AT&T and Verizon, with utilities. There are significant growth aspects to their current business models, even though many investment models have not accounted for that.

It appears that equity investors, market participants and investment models all augur for lightening-up on bond-like equities before the Fed hikes. However, they are looking at the wrong end of the curve. If the Fed hikes the Fed Funds Rate, it is the short end of the curve which should experience most,(possibly all) of any interest rate increases. This makes sense when one considers that a Fed tightening should result in a flatter yield curve. The bond market is responding precisely as I believe it should (see the earlier 2-year to 10-year benchmark curve chart).

The idea that all rates rise when the Fed hikes is common on the retail side of the business. Some wealth management model portfolio departments stress-test investment portfolios by assuming a parallel shift in interest rates. This rarely happens. If it did, the yield curve would not experience, often significant, flattening and steepening through monetary policy/economic cycles.The relationship between Fed tightening and a flatter yield curve has proved very durable over time.

UST 2-year to 10-year benchmark yield curve since 1977 (Bloomberg):

I have circled the beginning of the last three major tightening cycles. In every case, the U.S. Treasury yield curve has flattened. The UST yield curve also began flattening at precisely the time the Fed began tightening. The chart also indicates the UST yield curve flattened during minor policy tightenings, as well as the end of QE1 and QE2. The lesson to be learned is; when the Fed begins removing the punchbowl, the yield curve usually flattens. As such, the bond market appears to be responding as it should and equity market participants and models appear to be letting their ignorance show.

I would also add: long-dated U.S. Treasury yields are as low as they are, not simply because inflation is low and a modest increase in monetary policy rates promise to keep inflation tame. Foreign central banks are pouring money into U.S. Treasuries. Along with central banks’ usual purchases (10-year UST notes and 30-year government bonds), there was strong indirect bidder (which includes foreign central banks) demand for the 2-year and 5-year UST notes at last week’s auctions. As long as foreign economies are sputtering due to demographics and ill-conceived fiscal and regulatory policies, sovereign debt yields in Europe and Japan are likely to remain lower than they are in the United States. Add to this strong demographic demand for income by individuals, pensions and insurance companies and it is difficult to imagine long-dated UST yields rising dramatically.

There is something about the recent equity market rotation out of so-called defensive stocks into industrial and cyclical stocks that I believe deserves mention. Money has been flowing from defensive stocks to multi-national industrial stocks. The weaker USD has been a major catalyst for this rotation. The dollar has weakened on the diminishing prospects for monetary policy tightening. Thus, the argument that the equity market rotation is driven by expectations for higher rates does not hold up to scrutiny. (2) (5) (6) (7)

References:

(1) High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those gradedBBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

(2) International and emerging market investment involves special risks, such as currency fluctuation and political instability and may not be suitable for all investors.

(3) Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values may decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Many Municipal bonds are federally tax-free but other state and local taxes may apply.

(4) Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.

(5) The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

(6) The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. 

(7) All indices are unmanaged and may not be invested into directly.