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The Fed Should Be Paying Attention To The Yield Curve

Published 04/23/2017, 02:15 AM
Updated 07/09/2023, 06:31 AM

There nothing like uncertainty and speculation to prove everyone wrong! What am I talking about? Well, let's go back about a month to the last Fed meeting, when the committee raised the funds rate. This was the third hike in about 15 months, and 'only' put the overnight funds rate at .75%. By contrast, a normalized interest rate policy would have this rate around 3%. For all intents and purposes, the Fed is still accommodating the markets with low interest rates.

Recently, Fed speakers have said the economy is 'stronger', and as such can absorb rate hikes. This is due mostly to strength in the jobs market, housing market (somewhat) and a few other areas pointing to higher GDP. There are some weak areas of course, and those include consumer, industrial production and commodities. GDP for Q1 appears weak, and while a snapback is quite possible there is nothing in the data pointing in that direction.

So, the bond market is not going along with the thesis. In fact, they have gone the other direction and have completely dismissed the Fed's notion of a stronger economy. How do we know this? The long end of the curve - controlled by the bond market - is actually much lower than we would like to see in a growth situation.

Remember the worries over rising rates? Just after the Fed hiked, the worry was for the 10 yr bond to move above 2.6%. Now the worry is a break of 2%. Talk about having your cake and eating it too! Can't we all just get along? With rates hovering near 2% on the 10 yr it means the yield curve is flatter. This affects banks directly and materially, as the lucrative 'net interest margin' is something these banks have lacked for years.

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Further, with so much uncertainty and turmoil around the world, the safe haven trade is an easy call - buy US treasuries. There is little worry here, but if yields drop too low then we are looking at the alternative - right back into stocks, and then bonds sell off one more time. We'll see if that materializes on the horizon as we enter a rather 'dour' calendar period for stocks - the preaching of 'sell in May and go away'.

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