It sounds like disaster, doesn’t it? Short-term interest rates have soared from under 1% in a matter of months are are widely expected to hit 4% by the end of the year. However, the longer end of the yield curve has actually come down.
But here’s the catch: while these numbers apply to 2022, I’m actually talking about 2004-5, the last time the Fed had the courage to climb out of an easy money hole even if it meant raising recession flags.
Back then, the curve looked terrible. Even my old school Wharton was perplexed, admitting that nobody could really figure out why long-term rates moved roughly sideways while the Fed was ruthlessly raising the short end.
Alan Greenspan called it a “conundrum” but it taught us that the economy is more resilient and more mysterious than people like to think. After all, 2-year yields climbed above 10-year yields as early as December 2005 . . . a full two years from the start of what ultimately became the Great Recession.
And stocks kept rallying throughout almost that entire two-year period. If you cashed out when that segment of the curve inverted, when would you have gotten back in?
At the start of 2006, when market forces temporarily resolved the problem? Any time between March and June? September?
Remember, the housing boom didn’t really start unraveling until July 2007. It took 18 months for the disruptions the curve reflected to start playing out in the financial markets, and another six months to hit Main Street.
In fact, this segment of the curve repaired itself and looked healthy again by June 2007. If that was your “all clear” signal, I am sorry to say that you would have missed about 25 percentage points of progress on the S&P 500 and instead bought close to the top.
It took stocks six years from that “all clear” signal to fight their way back from their losses. Unless you can suggest a more sophisticated solution, selling the inversion and buying when the inversion ended didn’t provide any material benefit whatsoever.
And all of this assumes you’re content to simply buy and sell the market as a whole. Technology stocks collectively recovered a lot faster. The banks, on the other hand, took nearly a decade to recover.
Is the current inversion different? Maybe. The Fed is working through a different set of challenges, including unwinding trillions of dollars of long-term debt securities currently on the balance sheet.
As more of those bonds are allowed to mature without being replaced on the open market, a key source of demand evaporates. The Fed simply vanishes as a motivated buyer.
And when demand for bonds weakens, prices go down. Yields go up. That’s going to straighten out the curve to a tune of $3 trillion in the next five years.
I have no illusions that 10-year yields are going to climb much beyond the short end of the curve, so we might spend some time in a relatively “flat” world where the price of money doesn’t vary much no matter how long it takes loans to come due.
To be honest, that’s more a matter of housing policy than anything in the bond market. The government calls the tune on mortgage rates by structuring what the agencies will fund. If those rates get too high, the agencies can change the rules.
In that scenario, the natural spread between the short end of the curve and the long end will contract . . . no matter what the Fed does. If the Fed follows through and raises overnight rates to 4% by the end of this year, 10-year yields aren’t likely to climb a full 1.5 percentage point to compensate.
Maybe they’ll go up half that range and track excruciatingly close to overnight rates or even a fraction below. That’s not an economy killer or a market killer in itself.