The Fed Accelerates
Like all living things, the economy moves to a cycle. Your heart beats to a cycle, weather has a cycle, even the tone of the sound of the keyboard clacking has a cycle all its own. In the economy, there is a boom-bust cycle. The boom-bust cycle is just like it sounds. A period of economic strength, followed by a period of weakness, followed by strength, and the cycle continues.
Currently we are in the boom phase of a boom-bust cycle. In this case, the boom is defined as a period when monetary inflation and the suppression of interest rates create the false impression of an economy that is growing in a healthy way. In other words, this is a different kind of boom.
One thing that usually happens in a boom is there is a growing desire to borrow money on the short end of the yield curve, and invest it on the long end of the curve. In layman's terms, we like to borrow short and lend long. Banks do this when they pay you a small rate of interest for your savings, and make long-term loans with the funds. When the economy is strong, banks want to issue more loans, which raises their demand for short-term cash. This action tends to push short-term rates higher relative to their long-term cousins. This pressure normally causes the yield curve to flatten at this stage of a boom.
A simple way to see this in action is to look at the 10-year minus the 2-year spread over time to see if it is steepening or flattening. One thing we DO NOT have currently, is a flattening yield curve. Instead, the 10-year minus the 2-year yield spread is steepening at a fast pace. The current yield curve situation can be explained by the actions of the Fed.
The Fed has created a massive inflationary force that continues to this day as they pump newly created money into the economy. They are pushing short-term rates lower by buying bonds of shorter term duration and when they are due for redemption, they roll them over into new short-term debt. By creating demand for short-term bonds, they push the price higher than it would otherwise be. As you know, when bonds rise, yield falls, so their action is pushing the short end of the yield curve lower, while the high end of the curve is free to rise. By doing so, it is engineering its own yield curve, which is rapidly steepening.
A steep yield curve is an unnatural development at this stage of a boom-bust cycle. But, we doubt the Fed will do much to slow the steepening of the curve. In fact, the actions of the Fed are likely to encourage further steepening. From the Fed’s point of view, there are a few reasons to desire a steepening curve.
When the yield curve is steepening, it usually reflects rising inflation expectations. For now, the Fed would welcome rising inflation expectations, since they have repeatedly stated that inflation is too low.
Another reason is that a steep yield curve means banks can literally print money. The strengthening commercial banks can slowly take over the creation of credit and money, which is believed to benefit the economy.
In addition, higher yields on long-term debt helps the pension fund industry. In the markets, like with anything, there is no free lunch. While low rates assist borrowers, they do so at the expense of lenders. Pension funds are lenders when they buy bonds. Imagine how challenging it must be to earn a yield when interest rates are near zero, or even negative.
So far, the yield curve has reverted back to its long-term average of the past thirty years, but is on its way from being well below average, to what will probably rise to above average. We think the Fed will allow, and even welcome a further steepening of the curve. The question is whether the market will tolerate it. We are already seeing the Nasdaq adjust to rising long-term rates.
For now, we expect the yield curve to continue to steepen and the Fed to continue to keep their proverbial foot on the gas pedal. The banking sector should continue to benefit. You can take advantage of the steepening curve by purchasing a bank sector ETF or by looking for individual bank setups that offer a promising reward-to-risk ratio.
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