Recently, many investors and market pundits have been looking at the term structure of interest rates – also know as the “yield curve”- as a source of concern for equity markets. In the attached chart, courtesy of Ed Yardeni, one can see why: in many instances yield curve inversions have indeed been precursors to market sell offs. Of course, there have also been instances where inverted yield curves did not result in market sell offs. The key is the spread. At a positive 100 bps spread between Fed Funds and the 10-year note, the yield curve remains upwardly sloped and would clearly be in the territory that historically has allowed for a continuation of bull markets. A better question, perhaps, is why did the curve invert in the past? In ’73 and ’80 the Fed was tightening to curtail sharply increasing inflation. In ’99 and ’07 the Fed tightened to reduce “market excesses.” In those instances, Fed moves did lead to credit crunches which were the primary reasons for the subsequent market sell offs. However, if today’s yield curve moves were signaling a credit crunch, high yield spreads would be widening out sharply and they are not. They have barely moved all year.
Any credit spread widening we may be experiencing is more a function of increased credit demand in a strong economy, which have written about recently. In fact, per Federal Reserve data, commercial and industrial loans increased by nearly eight percent in the second quarter of this year and total credit expanded over three percent. Does that sound like a credit squeeze?
Lastly, European and Japanese interest rates remain at extraordinarily low nominal levels and at negative real rates. Among developed bond markets, the US is the only game in town. For global investors, a strong US economy and our high interest rates are very compelling. So the dollar strengthens, monies flow into longer term US government debt, and the yield curve flattens.
We believe when you look through the headline, thoughtful investors will see a flattening yield curve as a by-product of a strong domestic economy and a rate normalization process by the Fed; in isolation, it is not a factor that would cause us to change our otherwise bullish viewpoint on US equities.