Can You Take Me High Enough?
Those are lyrics from a song by the Damn Yankees, a group I know zero other songs from, but which makes me think about all the Yankees fans who are probably muttering about the Damn Yankees while their team is 11.5 games out of first place in the AL East.
Hey, at least they’re not the Mets who are 21 games out of first. But guess who’s IN first in the NL Central?? The Milwaukee Brewers. As a Wisconsin native, I take great pride in our small-market team showing up some of its big-market counterparts.
But this blog isn’t about baseball, nor the Damn Yankees. It’s about the inversion of the Treasury yield curve, when long-term bond yields fall below short-term bond yields, and its recent re-steepening. Can this re-steepening of the curve take us high enough to eliminate the inversion all-together?
Clearly the curve is still inverted (and thus, still sending troubling signals for the months ahead), but the move from -109 bps to -76 bps in roughly one month is notable — and tricky to read.
Typically, the re-steepening, or “un-inversion”, of the yield curve happens when 2-year yields fall faster than 10-year yields as the market prices in expected interest rate cuts by the Fed. Those cuts have historically been in response to weakening economic data or a negative shock of some sort. For example, in March of this year during the height of the regional bank distress, the yield curve re-steepened by 69 bps, with the 2-year falling 108 bps and the 10-year only falling 39 bps.
But that’s not what’s happening this time. There hasn’t been a negative shock and economic data has held up decently well, yet the curve has re-steepened. And it happened because 10-year yields rose while 2-year yields fell. Odd, what could that mean?
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To Fly Me Over Yesterday
The 10-year portion of the yield curve is more representative of long-term growth and economic expectations, whereas the 2-year portion is more representative of Fed policy expectations.
If 10-year yields are rising, that would intuitively mean that the market expects stronger economic growth than before (which also suggests higher inflation than previously thought, but that’s a topic for a different column). Looking at the Atlanta Fed’s GDPNow Forecast, economic growth is, in fact, expected to be stronger compared to prior estimates.
A rise in 10-year yields makes sense when lined up with this view. The problem is that the curve is still inverted. In order for it to have a positive slope again 2-year yields will need to fall at some point, or 10-year yields will need to rise another 75 bps.
The next problem is that both of those possibilities could present trouble for stocks. If 2-year yields are falling on the expectation of Fed rate cuts, something likely got worse in the environment. Conversely, if 10-year yields are rising, growth expectations are likely rising, but so is the threat of higher and prolonged inflation.
In an ideal world, 10-year yields stay put and 2-year yields fall very gradually as the Fed normalizes policy. That’s also possible. The result is likely higher yields (and interest rates) than markets have been used to for the better part of a decade. Although this would be the best case scenario, IMO, it suggests current stock valuations are too high.
Yesterday’s Just a Memory
In any event, yesterday will truly be just a memory. Case in point, rates couldn’t stay low forever, and the yield curve will not stay inverted forever. The Fed can’t keep hiking forever, and inflation won’t stay high forever.
The looming uncertainty is how and why all of these circumstances change to become just memories. The possibilities that would inflict pain on markets outnumber those that markets could survive unharmed, explaining the remaining caution and nervousness. I don’t expect there to be a single judgment day, nor a single moment in time when it all becomes clear. But the period in which we should be able to judge which outcome is more likely is quickly approaching.
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