The Fed And The Yield Curve


Every postwar recession in the U.S. was preceded by an inversion of the yield curve. Yield curve inversion does not mean that we will have a recession, but it has been a red flag in the past. Perhaps that is why the Federal Reserve is telegraphing to markets that it is leaning towards cutting short-term interest rates at its next meeting on July 31. Long-term interest rates have declined as U.S. and global growth expectations have come down. The Fed may feel as though it is behind the curve in terms of reacting to the message that the bond market is sending. It has a well-known history of reacting too late to deteriorating economic data, and it may want to be ahead of the curve this time.

Yet, what makes today’s inversion different than ones in the past is that we have the same situation in several other developed countries, including Australia and Canada. In countries where short-term interest rates are already zero or in negative territory, the yield curves are still inverted. These developments are having an effect on our yield curve.

I don’t think the yield curve is sending the same message today that it has in the past. If it was then, we would see bond investors demanding higher yields from corporate issuers relative to what they can obtain in the Treasury market. The current spread for investment-grade corporate bonds over Treasuries is just 118 basis points, which is lower than the five-year average. Note that during the earnings recession in the first have of 2016 spreads widened to 220 basis points.

The current spread for the lowest quality investment-grade bonds (BBB) is just 152 basis points, which is also below the five-year average. This spread reached 303 basis points in early 2016.

The current spread for junk bonds is 402 basis points, which is again below the five-year average. This is where we would see the pain start during an economic downturn, as can be seen by the surge in the spread to nearly 900 basis points in 2016.

It is possible that the corporate bond market is ignoring a pending downturn in domestic and global economic growth because of $13 trillion in debt securities around the world that have a negative yield. Lower long-term yields, if not negative yields, around the globe are dragging down long-term yields in the U.S. across the quality spectrum. This is a result of the decade-long global central bank plan to manipulate financial asset prices. They have collectively destroyed the pricing mechanism of the free market that warns us about impending risks. This is like driving a car down the highway with a blindfold on, and the Fed wants you to keep the pedal to the metal.

The one thing that the Fed can’t manipulate is corporate revenues and profits, both of which are derived from economic growth. On that front, things don’t look good. I suspect that it is a profit recession that concerns the Fed the most today, and the negative impact that it could have on stock prices and the wealth effect that has underpinned this expansion.

I think what’s more troubling for market valuations than a profits recession is the consensus forecast for a rebound in earnings once we move into the second half of this year. Bulls are rationalizing today’s valuations on a forward multiple of 17 times earnings, which is above the bull-market average of 14.8.

If earnings growth is going to rebound to double digits in the coming four quarters, then why does the Fed need to cut interest rates? If that earnings growth doesn’t materialize, then today’s market is a LOT MORE EXPENSIVE than 17 times earnings. That means there is likely to be a significant adjustment ahead, which could undermine the wealth effect. That is what I believe to be the Fed’s primary concern. More importantly, lowering interest rates from already historically low levels will have a minimal impact on the rate of economic growth and corporate profitability. Therefore, the Fed may be wasting what ammunition it has left. We are in uncharted territory, and I think that it is the Fed that is driving with a blindfold on. Don’t get stuck sitting in the back seat when this car veers off the road.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.





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