You’d think with all the geopolitical crises and a weak world economy that market fear and volatility would be high.
Instead, over the last month or so, we’ve seen a few fits and starts in the equity markets, but stock indices are still sitting close to all-time highs.
When the Fed raised rates last December, you would expect a yield curve that was getting steeper. That would signal an economy that’s getting stronger. The Fed would only raise rates if they thought the data supported it, right?
Wrong. The Fed raised rates because they were hell-bent on normalizing policy, not because the economy was getting stronger.
The Fed Chair, Janet Yellen, so much as said last month that the Fed isn’t really relying on economic data to make policy decisions. They’re reacting to risks from global economic developments.
Those global developments surely include what other central banks are doing.
That aside, the bond market shows that things may not be so great in the U.S. after all…
When there’s a steep yield curve, investors are speculating that strong economic conditions will spur inflation and that business is getting better. When investors buy longer-term bonds, they get paid a premium yield for the risk they’re holding. So when short-term rates go up, like when the Fed hikes the Fed funds rate, long-term rates usually go up even more in a normal market.
On the other hand, when the yield curve is getting flatter, it usually means that the economic outlook is bleak. Bank credit usually contracts and our economy just isn’t growing. A flat yield curve can even predict recession.
Let’s take a look at the yield curve from after the Fed hiked in December to now:
In the last three months, rates across the yield spectrum are lower. But the spread between short and long-term yields is more narrow, which means the yield curve is flattening. If a steeper yield curve foretells a strengthening economy, and the curve is actually flattening – are bonds foretelling recession?
Maybe, maybe not. But it sure isn’t predicting a rosier economy with higher prices or further rate hikes by the Fed!
I’ve asked this before: how can the Fed think about raising rates when central banks around the globe are cutting rates, going negative and pumping up the stimulus? I mean, just look at the yield curve of Japan compared to the U.S below:
Japan barely even registers! And just look at how much their yield curve has flattened. There’s hardly a difference between their two-year and their 10-year.
Comparatively, the outlook for Japan is bleak. The Bank of Japan (BoJ) has been stimulating, cutting rates and buying bonds for decades. They’re fighting a shrinking and aging population (demographics) and consumers that just don’t want to spend. But how can the Fed keep raising rates with this going on?
The BoJ, the Europeans, Chinese and others are all trying to stimulate their economies and exports. They hope that by devaluing their currencies through rate cuts and recently even negative rates that they’ll be able to achieve this. This is a race to the bottom that no one will win.
The effectiveness of these central bank actions have less impact the further they go. Remember when Japan went negative in January? They wanted to goose stock prices and weaken their currency but the opposite happened. Oops!
For now, all of this central bank talk and action has taken a lot of the volatility out of the markets. Stocks are still trading near all-time highs. This won’t last too much longer.
When traders snap out of their central-bank-induced heroin highs, look out below!
I expect there to be plenty of market volatility soon, which means there will be plenty of opportunity to make money! Overreaction in long-term Treasury bond prices is one way my Treasury Profits Accelerator subscribers profit.
Trading Treasury bonds may not sound sexy, but earlier this month we closed a three-month position for about 56%, and another that earnrned us 70% in a single day. As volatility comes back into the market, I expect to see more trades like this.
Editor, Treasury Profits Accelerator