Today is the Fed Day. As widely telegraphed to markets, the US Fed will be announcing its tapering plans. This entails purchasing fewer government bonds and mortgage-backed securities as part of its monetary stimulus package.

It is important to note that while similar ‘in intent’, that this is different ‘in form’ to increasing interest rates. The Fed has been at pains to stress this point and that ‘lift off’ of interest rates are still well into the future.

In simple terms if raising rates is seen as putting your foot on the brake, tapering is simply taking your foot off the accelerator.

If you are familiar with how bonds and yield curves work, you can skip to the next section (Inversion).

How bonds and yield curves work

We have written on this blog about bonds and bond yields many times. It’s the area that most casual market observers tend to ignore or dismiss as too complex. Yet bonds are remarkably simple. The most important thing you need to know as a casual reader is that when interest rates or bond yields rise, that the price of bonds fall.

The other important thing to know is that because most asset prices have an embedded assumption of a risk-free rate, that if rates rise, that valuations of other assets tend to be impacted.

Lastly, for the purposes of this piece, it is important to know that a yield curve is merely a series of yields at different maturities. Market participations look at the yield curve to imply the path dependency of rates over the medium to longer term. A normal yield curve is upward sloping (higher rates for longer term maturities) but when the yield curve inverts (higher short-term rates), this signals tighter policy and has been used as a precursor to economic slowdown.

Inversion

It does not hold in all instances, but an inversion in the yield curve has been noted as a potential flag to an economic slowdown and potential market correction. The chart below shows 3 periods where an inversion in the yield curve (10y vs. overnight) served as a lead indicator to a market correction.

 

Around June 2000, the Yield curve inverted, with the SP500 peaking in August 2000 around 1500 points and subsequently correcting to around 800 index points. That was the dot com bust.

In around August 2006 the yield curve inverted, with the SP500 continuing higher from 1200 to 1600 points into October 2007. It peaked there and commenced a correction which extended into the 2008 GFC down to around 700 points.

Lastly, in May 2019, the yield curve moved negative, briefly, but then the COVID pandemic hit, leading to a market and economic correction.

There are more examples in a longer time series but the point is illustrated. While not definitive, it is a risk flag worth noting and tends to lead corrections by anywhere up to a year. As such, it should not be used in isolation but in tandem with other indicators.

What’s the status quo?

At present, the yield curve remains positively sloped albeit remarkably flat.

Until recently, short term yields have remained well anchored. In fact, since 2020 and through the pandemic, they have been outperforming their long term counterparts. A lot of the ‘whipsaw’ has been in the 10y and beyond. On the 10y, we saw the yields rise since the July bottom but they now seem to be testing the trend line from below and may correct lower.

But that’s not the interesting part. Since June, the short end (US 2Y) has jumped from around 0.15% to current levels around 0.45%, this without the ‘whipsaw’ we saw in longer dated yields. If this decoupling continues, it would likely mean a flatter curve and possible inversion if extended.

This is why it is so important that we watch the  FED as well as the market’s reaction so closely.

Lift off?

For now, I remain in the camp of believing that central bankers are in a predicament of not being able to raise rates materially without upending the entire economy. Let’s face it, the economy is built on leverage. I’m not saying its right, its just the way it is.

The taper discussion and implementation will be a precursor and an experiment for the Fed to slowly gauge how resilient the market is without sending the shocks directly to the consumer yet. When and if that day comes, I believe that the answer may scare them…and perhaps into ‘low for longer/ever’.

But for now, there’s no point in speculating rather than watching and trading the signals as they arise. And that’s the hardest part. Not trading based on how you think the world should be rather than how the world is.

 

These blog posts are commentary. There is ALOT more beneath the surface.

For more detailed and in depth analysis of macroeconomic and markets drivers, and what they mean for your business and strategy, please reach out at moe@moe-knows.com to discuss your needs.

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MK White

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