Higher Rates Are to Blame. Lower Rates Are to Blame
Everywhere I turn, there seems to be
another reason for this correction. Slowing in Europe, China falling off
a cliff, tariffs, soaring long-term interest rates, yield curve
inversion, deceleration in the U.S. economy. I have heard it all. The
problem is that none of these reasons can easily be tied to the decline
directly, nor should they be. And every once in a while, declines occur
and the reasons are not apparent until well after the fact.
Let’s look at interest rates which has
probably been blamed more than anything else. You can see below on the
10 year treasury note from 2018 that yields had been moving much higher
all year. And they actually went straight up in September as stocks were
also rising sharply. During the sharpest leg of the stock market
correction in October, rates were somewhat all over the place. Yet,
since the beginning of November, rates have come way down, along with
stocks. It’s really hard to conclude that higher interest rates are
responsible for this decline.
More recently, pundits and the media have
been pounding the table about the yield curve boogeyman. The yield curve
on the short end has inverted. Perhaps you are wondering, “what the
heck is the yield curve and why on earth should I care?”
The yield curve is very simply the
difference between two interest rates or yields. For example, if the 10
year note is yielding 3% and 2 year note is yielding 2%, the yield curve
is positive by 1%. It’s always the longer maturity minus the shorter
one. Investors look at all different yield curve components ranging from
the three month treasury bill to the two, three, five and ten year
treasury notes and out to the 30 year treasury bond.
Almost all of the time, the various yield
curves are “ordered” properly, meaning that the 30 year bond has the
highest yield, followed by the 10 year, 5 year, 3 year, 2 year and three
month. The bigger the difference in the yields, the more stimulative
for the economy it is. That difference is also one way to gauge how
incentivized banks are to lend as they borrow on the short side of the
curve and lend on the long side. The bigger the difference, the more
banks may be willing to lend which is good for their economy and their
profits.
Anyway, last week, the yield curve for
shorter-term maturities inverted, meaning that the yield on the three
year was higher than the five year. Prior to that, the yield curve was
flat. You would have thought that someone literally flipped a switch to
recession as it seemed like the whole world woke up to a short-term
inverted yield curve and the economy was now in a tailspin. That’s
beyond idiotic and nonsensical.
First, we only saw part of the yield curve
invert. The 2/10 year yield curve which usually follows the 3/5
inverting hasn’t done so yet. Inverted yield curves do lead to
recessions and it is an accurate predictor, however, it’s not like
flipping a switch. There is usually several quarters to years of lag
time before recession hits. And stocks typically perform well in the
weeks and months after the 2/10 curve inverts which hasn’t even happened
yet.
With so many negative forces in the markets
today, it certainly has the look and feel of a solid bottom forming
with major rally coming amid continuing volatile conditions. Sticking my
neck out as I usually do, I would be surprised to see stocks fall off a
cliff from here. Just below 24,000 should provide a floor for now.
