The Bond Market Problem That Is Not Going Away
/The bond market keeps inching closer to rare territory.
Interest rates are rising across the board. Normally this would be just fine, if not for the fact that short-term rates are rising much faster than long-term rates. This poses a unique situation/problem in the weeks ahead.
The 10-year Treasury bond rate sits just above 3.0%. The 2-year Treasury bill rate is not far behind at 2.6%. If short-term rates eventually eclipse longer-term rates (as shown below), it would mean that the yield curve has "inverted" from a traditional curve. Normally, the longer the bond maturity the higher the interest rate, and visa-versa. Take a look at how the 2-year yield (orange line) has closed the gap versus the 10-year yield (blue line):
(chart created in stockcharts.com)
Notice how quickly the short-term rate has risen relative to the long-term rate? Yield curve inversion could be near.
So is yield curve inversion bad? Potentially, yes. Last month I wrote about this dark cloud of inversion that is hanging over the market. It is often the precursor to a change in the business cycle, which can signal that economic contraction is looming, as it did in the early 2000s and 2008. Take a look at how the stock market (S&P 500, green line) reacted once short-term rates hit their apex in these previous two instances:
(chart created in stockcharts.com)
The two regions shaded in red show where the 2-year Treasury rate peaked, followed by a decline in the U.S. stock market soon thereafter. Before going any further, let's be clear: None of this guarantees that short-term rates have peaked or that the yield curve will invert. Have those odds increased? Yes.
So what would have to happen from here for those two things to occur?
For the yield curve to invert, investors would essentially have to prefer owning long-term bond investments to shorter-term bonds. This would imply that they are comfortable tying up their money for longer periods of time. Such long-term bond demand would push corresponding yields lower. Meanwhile, if short-term rates continue rising -- likely through the influence of the Federal Reserve -- eventually the 10-year rate and the 2-year rate would criss-cross and the result would be inversion.
In a perfect world, long-term rates would continue rising at a pace consummate with short-term rates until business conditions tighten. This tightening could take a number of forms, such as a decline in corporate revenues/profits, a rise in unemployment or flattening wages. As the economy reaches that cyclical peak and then starts to decline, interest rates would then slowly come back down. Lower interest rates would then (in theory) stimulate greater investment via lending and borrowing, which would lead to the start of a new economic upswing.
We know it is never this clear-cut. So if we are looking for the answer to "Is this the market top???" you are not going to find it here. What I would say is this... If the market and economy are nearing a top, I would expect stock prices to remain flat as interest rates creep higher. Eventually, financing would become too expensive and investors would pull back from investing.
But the elephant in the room that might precipitate all of this is that relationship between short-term and long-term interest rates. Long-term rates are meant to be higher than short-term rates, for the simple fact that long-term investments carry greater risk, and therefore, should pay the investor a higher interest return. But if investors decide they are willing to tie up their money for a longer period and only earn a tiny spread for doing so, the yield curve would likely invert. Then it is anyone's guess what immediate impact that has on the stock market and the economy at-large.
In The Market...
The S&P 500 fell -0.5% this past week. Let's look under the hood:
(price data via stockcharts.com)
Stocks just could not maintain the momentum generated coming off the previous week's gains. All in all it was a pretty quiet week for stocks. With interest rates on the rise, dividend-paying sectors (Utilities, Real Estate) were the worst performers. Energy and Materials were the big winners. We are still looking to buy into the Energy sector but would like to see prices come down a bit first before doing so.
In the meantime, as you see below we purchased a Consumer Discretionary fund (XLY) for many accounts. This sector appears poised to make a move higher and based on our technical evidence it made sense to try and take advantage of that.
Finally, to no surprise bonds were down virtually across the board. Long-term Treasuries and Corporate Bonds were both down more than -1.0%. We continue to own a small position in each of these areas in most accounts. I will be looking to sell our Corporate Bond position in the coming week but will likely be a bit more patient with our Treasury position.
In Our Portfolios...
What's New With Us?
I am thrilled to announce that Joshua Baird will be joining our team next month as Executive Administrative Assistant! Josh is a graduate of Pacific Lutheran University and someone I am confident will bring great value and intellect to our firm in the months ahead. I am sure you will have a chance to meet and interact with Josh once he comes on board in June.
Have a great weekend,
Brian E. Betz, CFP®
Principal