Back to top

Why the Yield Curve Signals Health, not Danger

Read MoreHide Full Article

In the stock market turmoil of the past week, the most common culprit mentioned in the news is rising interest rates - and specifically the idea that rising rates signal an end to the free-money party that has helped the equity markets achieve one new high after another over the past several years.

As a general principal, rising rates do generally have the effect of dampening economic expansion and in turn equity prices, but when current debt-market activity is put in a historical context, we’re still far away from any sort of crisis.

Rising rates make borrowing more expensive for businesses and individuals and tend to slow activity both in CapEx spending by corporations as well as consumer purchases that are typically financed - like homes and autos. The flipside of course is that although extremely low rates tend to stimulate economic activity, they also eventually lead to rising prices and an inflationary environment that makes almost everyone poorer in real terms.

Since 2015, the Federal reserve has been on a well-publicized campaign to raise short-term rates from the zero levels necessitated by the financial crisis of 2008 and closer to their historical average. Starting with former Fed chair Janet Yellen and continuing with current chair Jay Powell, the Fed has now raised the Fed Funds target rate 25 basis points eight times. The equity markets absorbed each of these increases in stride, pushing to new highs as corporate earnings continued to increase even in a higher rate environment.

Based on current economic data – which points to strong GDP growth and only moderate increases in wages and consumer prices – Chairman Powell has communicated his expectation that the Fed will continue to raise rates gradually into 2020 and an eventual Fed Funds rate of 3 – 3.5%. This would still leave short term rates well below their historical average of around 5%.

This pattern of action by the Fed is more like easing back on the accelerator for safety - rather than slamming on the brakes. We’re still definitely moving forward.

The long end of the yield curve – which is controlled by market forces rather than directly by the Fed – has been sluggish to respond. The spread between short and long maturities tightened and the yield curve flattened over the past three years. Although this helps borrowers, it’s not necessarily a healthy sign for investors’ long-term view of the economy.

Picture two loans, one that will be paid back tomorrow and one that will be paid back in ten years. A rational lender would expect a higher interest rate on the ten-year loan in compensation for assuming a greater risk of fluctuating rates, inflation and the opportunity cost of forgoing other investments. The amount of that difference is a representation of both the borrower's and lender’s expectations for the future.

If the spread is especially low, it’s a signal that the debt markets aren’t expecting very significant economic growth. If the spread is very high, it signals that the debt markets may be expecting high inflation that would eat into the real return on the investment.

So what’s the correct slope of the yield curve? Like most other economic principles, the healthiest sign for continued steady economic growth with low inflation is something in the middle – which is exactly where we’re headed, and we're not even there yet.

Mortgage Rates

A common worry about rising rates is that they increase the cost of borrowing for the biggest purchase most Americans will ever make – their home. Higher interest costs do tend to reduce the amount customers can pay for a new home and have a dampening effect on overall home prices. While this certainly can have a negative effect on certain industries – like homebuilders and their suppliers – if it happens gradually, it can also be seen as a sign of general economic health.

As we saw in the mid-2000s, rapidly rising home values can induce consumers to make irrational decisions about their purchases. Greedily expecting outsized returns on real estate and the fear of being priced out of the market can induce people to make purchases at increasingly higher prices that are prone to rapid declines.

A healthier economy produces a steady supply of housing that consumers can view as a stable store of value that will keep pace with the prices of other goods and services – and that you can live in – rather than a speculative play in which they expect outsized profits in a short period of time. Booms and crashes aren’t healthy for any market; stable appreciation is.

Although the current rate on 30-year fixed mortgages recently topped 5% for the first time in over 7 years, just like the Fed Funds rate, it remains well below historical averages. Lending standards are considerably better than they were 10-15 years ago and there are no signs of any significant slowdown in housing starts or existing home purchases. At this point, the housing market be considered perfectly healthy.

Effect on Equity Prices

Obviously, many factors go into investors’ decisions to buy and sell stocks and the level of interest rates is only one - but in the absence of any other significant warning signs, it seems to be the single factor most in focus right now. Higher rates don’t affect all businesses equally and the recent broad market selloff probably paints the effects of rising rates with too wide a brush.

Financial stocks in particular tend to actually benefit from higher rates as the spread between the rates at which they can borrow and lend expands. We’ll see the first batch of Q3 earnings from the banks on Friday with releases from Wells Fargo (WFC - Free Report) , Citigroup (C - Free Report) , and JP Morgan Chase (JPM - Free Report) . The financials have lagged the broad markets so far in 2018 and these reports will be an important indicator of whether it may be the banks' turn to shine.

Think Like a Pro

Professional traders and investors rarely enter or exit a trade all at once, instead “scaling” in and out of positions as market conditions change. That’s an important lesson for individual investors. During periods of market turmoil, rather than panicking, use the opportunity to rebalance a portfolio away from a sector that may be experiencing headwinds and into those that will maintain or even improve their results. Maybe even use some cash from the sidelines to pick up an unfairly punished company that’s trading well off its highs.

Every market move is an opportunity for someone. It’s not always the easiest decision, but the future winning trades are out there somewhere if you look.

Looking for Stocks with Skyrocketing Upside? Zacks has just released a Special Report on the booming investment opportunities of legal marijuana. Ignited by new referendums and legislation, this industry is expected to blast from an already robust $6.7 billion to $20.2 billion in 2021. Early investors stand to make a killing, but you have to be ready to act and know just where to look. See the pot trades we're targeting>>



In-Depth Zacks Research for the Tickers Above

Normally $25 each - click below to receive one report FREE:

Wells Fargo & Company (WFC) - free report >>

JPMorgan Chase & Co. (JPM) - free report >>

Citigroup Inc. (C) - free report >>

More from Zacks Investment Ideas

You May Like