The Inverted Yield Curve

I am a "stock guy" and no longer the "bond guy" that I was in the 1980s. Still, though, I pay attention to bonds. When I was at Kidder, Peabody, may it rest in peace, in the the mid-80s after college, I was a bond trader. Sounds sexy, but it really wasn't. I was involved in collateralized mortgage obligations (CMOs) and asset-backed securities (ABS). I don't miss this at all! I loved living in NYC and working on Wall Street, which I deeply despise. I am celebrating my biggest NYC victory today, as it is the 34th anniversary of my wedding to Fran.

I came back to Houston in 1994 and remained in the bond business, but I escaped at the beginning of this millenium as I transitioned professionally to stocks. It's not like I was a newbie, as I started investing in stocks in 1978 at the age of 13. A family friend gave me 1 share of Pepsi as a gift, and he put me in my path.

Bonds play an important role in our lives, though many of us may not understand the full extent. For stock investors, interest rates, which are based on the price of bonds, impact stock prices. Those interest rates impact a lot more than stock prices! Interest rates play a role in how much housing costs (mortgages), or how much we can save by investing our cash. They impact all companies, not just publicly traded ones, that borrow money to finance their businesses. They impact the federal government, which borrows a ton of money. This can impact tax rates too.

Usually, interest rates are lower for shorter maturities than longer ones. In other words, a short-term debt, like the 2-Year Treasury Note, will typically be lower than a long-term one, like the 30-Year Treasury Bond. While this is usually the case and makes sense, it is not always true. Like now! We have had an inverted yield curve for a while now. Here are the rates for U.S. Treasury securities as of Friday:

• 2-Year Note: 4.90%

• 5-Year Note: 4.56%

• 10-Year Note: 4.52%

• 30-Year Bond: 4.63%

There are different ways to describe the yield curve, but what is clear is that the 2-Year Note is above all of these longer maturities.

The current situation is telling investors that rates are expected to fall in the future. This is consistent with what the head of the Federal Reserve, Jerome Powell, and his team have been saying. At the March meeting of the Federal Reserve Open Markets Committee (the FOMC), the Federal Reserve left its forecast for three rate-cuts in 2024. The last change in the Fed Funds, which is now 5.25-5.50% was in July, when it was boosted by 25 basis points (0.25%). In March of 2022, the Federal Reserve had the initial lift, raising it to 0.25-0.50%.

Stock investors have been excited by the potential rate-cuts ahead, and the inverted yield curve reflects this optimism as well. Recently, though, monthly inflation reports have been worse than expected, and this has reduced the expectations of the timing and the extent of potential rate cuts for the Fed Funds.

Looking back at the move down for Fed Funds, the FOMC took dramatic action in March 2020 when the pandemic hit. It lowered the rate to 1.00-1.25% on March 3rd, and it sliced it to 0-0.25% on March 16th. This was very low! I think that the FOMC helped prevent problems for our economy with those low rates.

Is the market right to think that rates will go back down? I don't think so, at least not soon. This has been my view for a while. Unemployment is very low right now. Earlier this month, we learned that the unemployment rate is just 3.8%. Inflation remains somewhat high, though it is lower than it was.

One's view on the current level of interest rates probably depends upon one's age. I remember when I started working on Wall Street in 1986 that 8% was considered very low for a 30-year Treasury Bond yield. I remember how in the early 80s, when the country was fighting inflation, Paul Volcker, who was leading the Federal Reserve, allowed Federal Funds to go very high. Yields on Treasury obligations soared. As bad as it was, inflation was beaten.

For younger people, rates may seem high. We are a lot higher than we were recently! Here is the 10-Year Treasury Note yield over the past 18 years:

So, I get it. Rates have risen a lot and are higher than they were at the peak in 2008. But, they aren't that high. Most importantly, the Federal Reserve doesn't need to lower rates to help the economy, as unemployment is rather low.

If rates don't fall, as the inverted yield curve suggests, investors are going to be disappointed. Those buying the 10-year note under 5% and a discount to shorter-term notes will probably lose some money. Stock investors, though, have more at stake in my view. I have recently shared my negativity on stocks, and I remain cautious. If rates don't fall, and I don't think that they will, the downside on stocks could be significant. I reiterate the parts of the market that alarm me: the very large market-caps and technology stocks.