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Watching the Yield Curve

| June 26, 2017
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According to the good folks at Investopedia, the yield curve is a “line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.” The most frequently reported yield curve compares the three month, two year, five year, ten year and thirty year U.S. Treasury debt. This yield curve is used as a starting point for calculating the borrowing rate on other debt in the market, such as mortgage rates or bank lending rates, as well as for attempting to predict changes in economic output and growth.

Generally speaking, when the yield curve “flattens”, most often as short term rates rise and long term rates stay the same or fall, investors become nervous at the possibility of economic and stock market weakness. The fear is that the Federal Reserve will raise short term rates too fast, causing the economy to slow, corporate earnings to fall, and stock markets to follow suit. Slowing expected economic growth is reflected in lower long term rates, thus completing the circle and flattening the curve even more. As the economy moves through recession and the Fed responds by lowering rates again, the curve steepens, markets begin to anticipate recovery, and the cycle begins anew.
 
While the scenario outlined above is an over-simplification, the fear is real among investors and warning flags will fly when an economic expansion is long in the tooth and the Fed starts raising rates, even from such low levels as exist currently. We would call the yield curve at present a “yellow flag” from the bond market warning the Fed that its current course of raising interest rates may begin to threaten the domestic stock market’s carefree march to record highs.
 
The yield curve initially steepened heavily in the wake of last year’s presidential election, as investors grew more hopeful that President Donald Trump’s promised economic policies could improve economic growth and lift inflation. But, for most of 2017, reinforced lately by weakening oil prices, it has deflated just as quickly. The difference between two and ten year Treasury yields, a popular measure, has fallen to 80 basis points (“bp”), equal to just 0.8% and close to the nine-year low of 75bp touched last summer.
 
Granted, investors are often as poor at forecasting recessions as professional economists, with the old joke that the stock market has predicted 10 of the last 4 recessions. But the yield curve has been pretty accurate in predicting domestic economic downturns since WWII, and concerned chatter is getting a little louder these days. The economic pessimism signaled by long-term U.S. Treasury yields stands in sharp contrast to the enthusiasm in the stock market, and many investors are wondering just how long this current divergence can last.
 
We will have more to say about the yield curve and the U.S. stock market in the coming weeks. In the meantime, we wanted our clients and friends to know what is on our minds these days, and will continue to keep you apprised of our thoughts as ongoing events dictate.

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