There has been a lot of chatter lately about bond yields. This is interesting, because equity investors and traders rarely pay much attention to bonds or the yield curve until it really matters.
Well, we have come to that point where it does matter. The Federal Reserve is finally going to loosen up their monetary policy after more than two years. So far in 2024, investors have been cheering this pivot with positive equity returns, believing looser conditions will bring about easier gains in the stock market.
So, what are equity investors curious about when it comes to fixed income? The yield curve. More specifically, the spread between 2-year and 10-year yields. This differential usually slopes upward from the 2 to the 10 with a time premium in between.
For example, if the 2-year is yielding a 3% return, we might see the 10-year yield at 3.6%. (You get paid a higher yield for loaning your money out for a longer time period.)
There are plenty of other yields, so why do we care about the 2-year and 10-year? The 2-year is an important gauge of Fed policy, while mortgage rates appear to be pegged toward the 10-year yield (because many homeowners tend to sell out or rollover their loans at about 10 years).
But following the pandemic, yields were wacky and the curve inverted severely. This meant tighter monetary conditions were present. The 2-year was paying much more than the 10-year. Panic was setting in as investors did not want to lend money beyond a certain time period.
In years past, this inversion tended to predict a recession. (In fact, in all seven instances over the past 60 years when this happened, a recession always arrived.) So, when the curve inverted and stayed that way for quite some time, everyone was worried for good reason.
Recently, the yield curve has flattened out, and that tells us looser conditions are on the way. It’s going to be messy getting to a more normalized curve. The bond market is crying out for the Fed to notice that rates are lower on the long end of the curve. We think the Federal Open Market committee is listening and will respond, but the yield curve is fragile. Without some hand-holding there is big risk of massive selling in both stocks and bonds.
