The Bond Market Is Tightening, The Fed Is In A Box, And The Economy Will Pay.

The yield curve is steepening. It follows the historical script dictated by the business cycle. This time it means a tightening action by the markets.

Source: St. Louis Fed

This is an incredible chart. Its implications could be particularly important for investors and strategists. It shows three yield curves measured as the difference in yields of Treasury instruments between 10-2, 5-2, and 10-5 years.

A rising curve means the spread between short-term and long-term duration instruments is increasing and the yield curve is steepening. The decline in the graphs shows the opposite – spreads are narrowing, and the yield curve is flattening.

There is another interesting pattern. The yield curve starts steepening just ahead of a recession (shaded vertical area). In more general terms, it starts steepening ahead of a period of slower growth in business activity.

The explanation requires more details, especially if one wants to understand what is happening now and why the Fed has become irrelevant. It may show how its past policies have resulted in an abdication to monetary policy, leaving the tightening and easing of monetary policy to the markets.

Source: St, Louis Fed

Let me explain. First, we need to look at the historical patterns of interest rates (see above chart). Shaded areas show recessions. The first behavior is that short-term interest rates (blue line) change more rapidly than the long-term ones. Then, interest rates peak close to the beginning of a period of slower growth in the economy, just ahead of a recession. The decline in short-term interest rates can be justified in two ways. 

The business cycle was already slowing down before the peak in short-term interest rates. Business borrowing was declining as managers tried to reduce overstocked inventories. The decline in short-term interest rates was further reinforced by the easing action of the Fed as it recognized the dangers faced by the economy. The sharp increase in money supply M1 always accompanied the decline in short-term interest rates. 

The decline in interest rates and the easing of the Fed helped to cushion the weakness of the business cycle. This process was discussed in detail in a previous article. Eventually interest rates rise again after about one to two years following the end of the slowdown/contraction in business activity.  

The reason the yield curve steepens (see first chart) as the economy weakens is due to the relative movements of short-term and long-term interest rates. Short-term interest rates decline rapidly compared to the trend in bond yields. The action of bond yields, on the other hand, is muted by the sharp decline in short-term interest rates.

What has been happening in the past year is different from what has been happening in earlier cycles. M1 has been soaring but is not having any effect on short-term interest rates because they are zero percent. It is making the current economic and financial environment more fragile than in the past.

Source: StockCharts.com

Yields move in synchronism with the business cycle. They rise when our business cycle indicator rises, reflecting a stronger economy. Yields decline as soon as the business cycle indicator declines, reflecting the beginning of an economic slowdown.

The crucial point is that yields rise because they are driven by market forces and by a strengthening economy. This is what history shows. Let’s go back now to the issue of the meaning and implications of the recent steepening of the yield curve, presented by the press as a positive sign for the markets and the economy.

The current rise in yields is a form of tightening because it is not compensated by a decline in short-term interest rates. The markets are raising the price of money. Rising prices may be a positive sign in the near-term. Protracted increases tend to discourage borrowers – business and consumers.

In earlier cycles, the Fed responded to an economic slowdown by encouraging the decline in short-term interest rates. It did so by aggressively increasing liquidity – M1. The steepening of the yield curve, in other words, reflected mostly the easing of the Fed. This cycle is different, much different from the past. Yields are rising, driven by market forces -- the same market forces driving the business cycle. Yields are rising and are making money more expensive. 

Liquidity is plentiful. Money has been printed aggressively for more than a year. This time, however, the Fed cannot lower short-term interest rates and make money “cheaper.” This time they cannot do it because short-term interest rates are zero percent. Yes, there is a lot of liquidity (debt). But this debt has historically had a negative impact on the growth of the economy over the long-term.

Business and consumers respond to the price of money. What they see is rising interest rates. This perception and reality are a form of tightening because it discourages borrowing. The Fed cannot do anything about it.  More debt (stimulus) will not work as it did not work for several decades.

Key takeaways

The markets have been tightening by raising the cost of long-term money. The Fed cannot do anything about it. They cannot lower interest rates because they are at zero percent. More debt (stimulus) cannot overcome the tightening caused by rising bond yields.

The business cycle is much closer to the end of Phase 2 (strong growth phase) than the beginning of Phase 1 (beginning of the expansion phase).

The business cycle indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management on www.peterdag.com. (Complimentary issue is ...

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Harry Goldstein 3 years ago Member's comment

These days, everyone wants to borrow, no one wants to save.

George Dagnino 3 years ago Contributor's comment

Agree.

Simone Radcliffe 3 years ago Member's comment

Yes, the steepening of the yield curve is a sign of imminent recovery.

George Dagnino 3 years ago Contributor's comment

Yes, but watch the trend of bond yields.

Texan Hunter 3 years ago Member's comment

American is in a lot of trouble. And unfortunately will only get worse with the Dems in charge. Trump may not have been perfect, but at least he was making America Great Again. Sadly most Americans don't seem to want that and voted him out of office.

Kurt Benson 3 years ago Member's comment

Good charts. Sounds like the worst may be over.

George Dagnino 3 years ago Contributor's comment

...as long as yields do not rise "too much".....you can enjoy a complimentary subscription to THE PETER DAG PORTFOLIO STRATEGY AND MANAGEMENT by going to www.peterdag.com....it will give you more insights on my thinking. (no c.c. needed)

George Dagnino 3 years ago Contributor's comment

Yes! But we need to watch closely the rise in bond yields.

Kurt Benson 3 years ago Member's comment

Very good point @[George Dagnino](user:152167).

George Dagnino 3 years ago Contributor's comment

Thank you!!!...You can enjoy a complimentary subscription to THE PETER DAG PORTFOLIO STRATEGY AND MANAGEMENT by going to www.peterdag.com....it will give you more insights on my thinking. (no c.c. needed)