Everyone is Watching the Yield Curve

Today’s Market

By most accounts and across many markets and asset classes, the term “frothy” can be used to describe current conditions. Over the past year, stock market indices have hit record and unprecedented highs, real estate values across the country have hit record benchmarks in both residential and commercial sectors, and inflation has driven up the cost of daily products ranging from beef to refrigerators. Now, with employment having nearly reached its pre-pandemic level, the Federal Reserve is well into its asset tapering program, buying fewer government and mortgage securities each month. On Wednesday of this week, January 26, 2022, Jerome Powell, Chairman of the Federal Reserve, gave his public address following the Fed’s earlier official announcement in which he outlined the Fed’s tapering to conclude by the end of March 2022. This process has been the primary driver of increasing mortgage interest rates over the preceding several weeks.

Though there was no direct mention of a movement in interest rate policy beyond the Fed’s customary “observation of the data” position, the raising of short-term interest rates is anticipated to commence around the same time as the conclusion of the tapering process. Though the market has been pricing between three and four rate hikes this year, the catalyst to much of the past week’s stock market volatility, a real reaction will likely not be observed until rates actually begin to move and those effects can be seen in the bond market. All of this activity, collectively, has financial markets and, by extension, the broader economy, looking for signs of the dreaded inverted yield, the accepted benchmark of pending recession.

The Yield Curve

An inverted yield is simply longer-term securities paying higher coupon rates that shorter-term securities. The yield curve itself is a long-term measurement and display of individual U.S. Treasury bonds and their individual rate movement laid atop one another. The general idea is that the long end of the curve, longer term treasury bonds, 10-year treasuries for example, should be paying higher rates than shorter term treasury bonds. The inversion of those two rates where, say, the 2-year treasury is paying a higher rate than the 10-year, indicates to the market that it is less bullish on long term investment and is demanding a greater return for short term investment. This inversion has predicted every modern-day recession, though timing has always been the most important moving factor with the response by the Federal Reserve being the “corrective” tool used to revert to curve to its normal state. Historically, from the date of the inversion, there has been between a 6-month and 24-month lag time from inversion to recession.  

The worry today is that the Fed has kept rates so low for so long that, following the completion of its tapering process, it will raise rates too fast and by too much, resulting in economic and capital movement disruption which would likely result in the inversion of the curve. This could send markets into a fear-based sell-off and potentially pull the trigger on the recession countdown. The Fed would then likely step in and either reverse its rate tightening policy and/or resume its quantitative easing vehicles (bond purchases) to calm markets. Due to Fed policy being as loose as it has been for the past 15 years or so, the market would then worry about Fed over correction, sending financial and asset based (real estate) market values further to the moon. The result of this could very well be catastrophe. After all, asset prices, whether financial or hard assets, are higher now than they have ever been historically in both nominal terms and performance metrics such as P/E ratios, affordability index ratings, etc. Should all of this be cause for concern?

Should we Worry?

The short answer is kind of. Given the trajectory the Fed announced on Wednesday of this week, we can reasonably mark this period as the top assuming the Fed will follow through on its plans. That would then mean, at best, we hover in a static position with a modest decline in asset prices to follow. That would not necessarily be a bad thing.

Economic concern is conditional, related to time horizon and centered around whether we are talking correction or collapse. There are, of course, always causes for worry in today’s geopolitical, socio-economic, and socio-political environment. We have both an abundance of cheerleaders of the financial sector as well as bears who endlessly pontificate about market collapse and total financial ruin.

Within the U.S., the Fed is attempting to unwind the largest balance sheet in the history of the world. That is no small task and the balance that must be struck between asset purchases, asset selling, rate policy, market liquidity, and timing is no small feat. If the Fed were to screw up, the global financial system could collapse. Liquidity within markets could freeze (repo markets crashed briefly in 2019), lack of capital availability could lead to private sector seizure, mass layoffs, defaults, and so on. In short, it would be ugly.

Fortunately, U.S. banks have been made excessively liquid through quantitative easing and excess deposits that have been made over the past year through stimulus. This “should” allow for sufficient liquidity for institutions to continue loan origination and productive operation through a tightening cycle. The overall hope is that through tapering, then tightening, and eventually unwinding, the economy will stop its years long binge on cheap-to-free credit and will reach an equilibrium balance between risk and return.

We must also watch the corporate bond sector very closely as rates rise and debt becomes more costly. Corporate debt has surpassed $11 trillion and has been on an issuance frenzy over the past several. Companies simply will not be able to issue the volume of debt they could with lower rates and as debt matures, we must watch defaults closely to identify those that are most troublesome.

Within the residential real estate sector, despite some reports of increasing supply, we remain years behind in inventory. Though new product is coming to market, it is not coming fast enough, and in states such as Florida, there is no perceivable end in sight to residential demand. Mortgage security tapering in conjunction with rate tightening may provide the needed brakes to residential values and bring the market back to some semblance of normal-ish behavior, but only time will tell.  

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