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

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. 

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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 1 month ago Member's comment

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

George Dagnino 1 month ago Author's comment

Agree.

Simone Radcliffe 1 month ago Member's comment

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

George Dagnino 1 month ago Author's comment

Yes, but watch the trend of bond yields.

Texan Hunter 1 month 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 1 month ago Member's comment

Good charts. Sounds like the worst may be over.

George Dagnino 1 month ago Author'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 1 month ago Author's comment

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

Kurt Benson 1 month ago Member's comment

Very good point George Dagnino.

George Dagnino 1 month ago Author'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)