We’ve been fielding concerns about the Treasury yield curve since December, when middle-maturity government debt started to pay lower interest rates than shorter-dated counterparts. That’s an unusual situation because when investors have to wait longer to get their money back, they’ll naturally demand bigger yields.
The good news is that with the Federal Reserve likely to cut overnight lending rates in a few weeks, the curve is now finally unwinding what initially looked like an ominous recession pattern. While we’re still in an environment where 3-year Treasury yields are lower (1.81%) than 1-month bills (2.16%) and everything in between, at least the ends of the curve are moving in the right direction again now. A rate cut can make things better and relieve the recession pressure.
Back in March, most Treasury rates were clustered in an extremely tight band between 2.41% and 2.52%, with very little visible logic keeping the lowest rates on the short end and the highest ones reserved for longer-term debt. Investors got less from 5-year notes than 1-year bills, while 1-month bills paid more than 3-year notes. The most ominous thing of all was the extremely narrow spread between all of these maturities, hinting that the bond market had effectively given up on higher rates before 2026 at the earliest.
Since the Fed has historically needed to tighten as the economy expands, scenarios when rates have peaked generally point to a recession ahead. Similar yield curve inversions preceded all previous recessions in living memory, so this one gave the doomsday theorists plenty to talk about.
However, not every inversion foreshadows a recession, especially when the abnormal rate relationships only apply across part of the curve. This time around, the weight on investors’ minds was all about the dynamics of the curve itself and not the underlying economy. The Fed is tackling that confusion at the source.
Last year we heard persistent complaints that 3% is a hard ceiling for 10-year bond yields. Whenever long-term rates got that high for an extended period, stock investors got nervous and fled to the relative safety of bonds, pushing prices up and bringing the yields back down to “tolerable” levels.
(Remember, prices and yields always move in opposite directions, whether you’re dealing with Treasury bonds or our dividend-oriented recommendations. Buying low locks in a high effective return. Buying high locks in less real income.)
But while the far end of the yield curve became capped at 3%, the Fed kept pulling the near end up 0.25% per quarter throughout last year, compressing what was once 1.50% of room between the extremes to barely 0.48% today. After all, when the Fed makes overnight borrowing 0.25% more expensive, the rates on longer-dated loans need to go up too in order to give investors a reason to lock up their money for even a few weeks longer. That’s exactly what happened. Since the end of 2017, the Fed raised the overnight rate from 1.25% to 2.50% and 1-month Treasury yields moved up from 1.29% to peak at 2.51%.
Meanwhile, 10-year yields remained stalled at 3.0% and often dipped below 2.5% when the market shuddered, forcing every point on the curve in between to flatten out or even drop below overnight rates. That’s just the return investors were willing to accept in exchange for relative safety. They weren’t looking for big interest. All they wanted was a secure place to park their funds.
Since the Fed acknowledged that it’s willing to not only “be patient” about future rate hikes but actively cut in order to keep the economy on track, the short end has plunged 0.35% to 2.16%, and a month from now it will be even lower. Longer-maturity bond rates have dropped too, but not as much. There’s now a fraction of a point more room between the extremes.
The curve is getting steeper again in the right direction, with the near end dropping and the far end staying roughly where it was. If 3.0% was the ceiling on the far side, evidently the only way to buy a little breathing space was to reduce pressure on shorter-term rates. That’s the part the Fed can control, and it’s doing so now.
What this means for us is simple. First, as bond rates start declining again, investors who were never happy settling for 2% at best now need to look elsewhere to earn real income. That’s constructive for our High-Yield recommendations that pay a lot higher in exchange for what we consider only fractionally higher risk.
In general, lower bond yields support higher earnings multiples. Old-school valuation techniques suggest that a stock worth 13X earnings in a 3% world can go all the way to 20X when the Treasury market struggles to pay more than 2%. We don’t anticipate huge moves from the Fed, but if you were worried about stocks getting frothy, the story is about to change.
And needless to say, cheaper money helps corporate executives dream a little bigger. They can fund larger and more transformative acquisitions or simply borrow enough to buy back more stock. Those with relatively weak balance sheets (we can’t think of any on the BMR list) get a second chance to clean things up before their debt starts choking them.
Throughout the process, consumers can keep spending without feeling the drag when the monthly bills come in. Lower rates are a boon for housing and auto markets. In a struggling economy, that’s the cushion that keeps the wheels turning. Here when the only apparent problems are tensions overseas and a persistent absence of inflation at home, the bulls get plenty of room to run.
Sooner or later recessions become inevitable. But with the Fed on the move, the yield curve now looks more like what we experienced in 1998 than any real pre-recession rate shock. Back then, Alan Greenspan jumped to correct a partial inversion in the face of tensions overseas. It took 33 months for the economy to contract. Investors who bailed out on stocks on the first glitch on the curve missed out on a 50% boom and had plenty of time to reposition themselves when it was clear that the party was finally over.
The party’s not over yet. We might have years to let our winners ride. Either way, we’ll be watching . . . and the Fed is alert as well. Want a taste of our research and market commentary? All the details are right HERE.