As in­ter­est rates again reach record lows, watch out for the yield curve

Financial Mirror (Cyprus) - - FRONT PAGE -

Lo and be­hold, af­ter all the talk of in­ter­est rate hikes and grad­u­ally tight­en­ing mon­e­tary pol­icy from the Fed­eral Re­serve, U.S. in­ter­est rates on the 10-year bond have touched record lows yet again. The record low came on July 24, 2012, when 10-year rates hit 1.394%. On July 5, we hit a new all­time low at 1.39%. On the long end of the yield curve the record has also been bro­ken, as the 30-year hit and broke the record low of 2.226% set on Jan­uary 30, 2015. Now 30year rates are 2.16%. Bond ETFs are re­flect­ing this, with the Van­guard To­tal Bond Mar­ket ETF, which tracks a wide in­dex of U.S. bonds in­clud­ing govern­ment and cor­po­rate, just be­low record highs.

For bond in­vestors this is great news, but there are hidden dan­gers here in the yield spread. The Fed­eral Re­serve, de­spite not rais­ing rates this year, did raise the ef­fec­tive fed­eral funds rate back in De­cem­ber, which means that the overnight rate has risen slightly while long-term rates keep fall­ing to record lows. Higher short­term rates and lower long-term rates mean a neg­a­tively sloped yield curve, com­monly de­fined as 10-year mi­nus two-year rates. Fur­ther ev­i­dence that the yield curve is get­ting squeezed is the fact that five-year yields are nowhere near record lows set in 2012. This bond rally is pri­mar­ily af­fect­ing the long end, less so the short end.

Ev­ery re­ces­sion since at least 1976 has been closely pre­ceded by a neg­a­tive yield curve. The func­tional rea­son for this is that the smaller the spread be­tween long-term and short-term rates, the less money banks can make by bor­row­ing short and lend­ing long, which is ba­si­cally the en­tire busi­ness model of the en­tire global bank­ing sys­tem. When the curve goes neg­a­tive, it means banks are pay­ing more to bor­row than they earn to lend, which ob­vi­ously dis­cour­ages banks from lend­ing money and this slows down mon­e­tary ex­pan­sion, lead­ing to busi­ness cy­cle crashes. This is why the yield curve rarely fails to pre­dict an im­mi­nent re­ces­sion.

The yield curve has trended down­ward for over five years now, since Fe­bru­ary 4, 2011, when it hit a record high of 2.91. We are in an era of con­tin­u­ous record-breaking it seems, and the yield curve is no ex­cep­tion. An­other omi­nous record since 1976 and pos­si­bly longer is the amount of time the curve has re­mained pos­i­tive. The last time we had a neg­a­tive yield curve was in May 2007, about five months be­fore the Great Re­ces­sion be­gan. The econ­omy has ef­fec­tively en­joyed a pos­i­tive yield curve for over nine years now. The last time it was neg­a­tive be­fore 2007 was in March 2000, when the Nas­daq bub­ble popped.

Bond in­vestors may be cel­e­brat­ing now, but the lower long-term rates go with­out bring­ing short-term rates with them, the closer the yield curve gets to neg­a­tive ter­ri­tory, and the closer we are to a ma­jor re­ces­sion.

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