THOUGHTS ON THE YIELD CURVE
WHAT DOES IT MEAN? ... Earlier this afternoon I did an interview with Ron Insana on CNBC. Our discussion was about the recent drop in long-term bond yields -- and the implications of the flattening yield curve. I thought I'd elaborate on the subject since it's not easily understood. A normal yield curve has a positive slope moving from left (short-term rates) to right (long-term rates). That's because long-term rates are normally higher than short-term rates. When the economy is weak, the Fed lowers short-term rates. That widens the spread between short and long-term rates (a steeper yield curve) and paves the way for the next economic recovery. At present, the opposite is happening. The Fed started raising short-term rates in the middle of last year. As a result, the spread between short and long-term rates has been narrowing. Normally, a narrowing yield curve takes place when short-term rates are rising faster than long-term rates. What's unusual this time is that long-term rates are actually dropping. The question is whether that's a good or a bad thing.
WHY A NARROWING YIELD CURVE CAN BE DANGEROUS... The danger point in a narrowing yield curve comes when short-term rates move higher than long-term rates. That's called an inverted (or negative) yield curve. The last time that happened was at the start of 2000 and preceded a major bear market and recession. Every recession in the last forty years has been preceded by an inverted yield curve. We're nowhere near that point yet. But we're moving in that direction. Not enough to cause a recession, but maybe enough to cause some economic slowing. Most economists are putting a positive spin on falling bond yields since that's traditionally good for the economy and the stock market. Their view is that falling bond yields are simply a sign of lower inflation expectations. But it's also possible that falling bond yields are hinting at a weaker economy. Bond yields fell sharply last Friday on a weak jobs report. Fourth quarter GDP came in way below expectations and was the weakest of the year. That's also pushed yields lower. The fact that bond prices have done better than stocks so far this year also suggests a more defensive attitude on the part of investors. Then there's the impact of falling bond yields on the yield curve.
FALLING BOND YIELDS MAKES YIELD CURVE FLATTER ... To the extent that a flattening yield curve can become dangerous, a drop in bond yields isn't necessarily a good thing. The Fed has expressed its intention to keep raising short-term rates. If long-term rates continue to drop (or even stay flat), the yield curve will flatten even further. [Rising short-term rates and falling long-term rates narrows the spread between them]. That's not necessarily good for the economy or the stock market. Economists have expressed puzzlement at why bond yields have stayed down so long in the face of a strong economy. The one possible reason that they never seem to consider may be the most obvious -- namely, that the economy isn't as strong as most economists believe that it is.
SECTOR ROTATIONS FAVOR A WEAKER ECONOMY... From a stock market standpoint, I've already expressed my view that the cyclical bull market that started in October 2002 is nearing completion. Any ensuing weakness in the stock market would be a precursor to economic softening. Energy stocks remain the market's strongest sector -- while technology is the weakest. That's a bad combination for the stock market. The fact that consumer staples and utilities have been market leaders early in the new year (along with energy) is a sign that the economic cycle could be peaking. Then there's the January Barometer which gave a negative vote for the market this year. A little known aspect of January's performance is that sector leaders during January often lead for the entire year. And sector laggards often lag for the balance of the year. That's another vote for defensive market sectors -- especially energy. If rising energy shares are hinting at higher oil prices, that's not going to be good for the rest of the market or the economy. Maybe that's what the bond market is telling us.
