Is the Yield Curve Throwing Off the Wrong Signals?

Bond indices

US markets look ready to turn back down over the next few weeks. The Dow and S&P 500 fell around 1% on Friday thanks to ongoing weakness in retail stocks…despite economic data indicating consumer strength!

This strong data showed retail sales growing at the fastest pace in a year. In turn, the US dollar jumped as traders increased their bets on an interest rate rise in the coming months.

But it’s not all unicorns and lollipops for the US economy. Friday’s data saw the US yield curve (the gap between two and 10-year bond yields) flatten to its lowest point since 2007.

What does this mean?

Well, when the yield curve flattens, it indicates worries about economic growth. In a healthy economy, long term bond yields should be higher than short term bond yields.

But that isn’t the case in the US right now. While current growth is OK, the market is saying that, if the Fed responds by raising interest rates, it will cause a sharp slowdown.

Which means the Fed won’t raise interest rates!

A flattening yield curve isn’t good for banks. They make their money from borrowing at short term rates and lending at long term rates. The difference is the ‘spread’ that they earn.

So it shouldn’t be a surprise to hear that US bank stocks fell 1.6% on Friday, in response to the action in the treasury market. Everything is connected…

That leaves the S&P 500 looking vulnerable. As you can see in the chart below, the index failed to make a new high in April, and in early May made a lower high. If it breaks the recent lows then you’re likely to see the index head considerably lower in the coming weeks.

It will be back in correction territory and fears about a big bear market (GFC Mark II) will mount. But there’s a long way to go before we get there.

Source: Market Analyst

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The US Fed isn’t the only central bank worried about the yield curve. A flattening curve in Australia (signifying a weaker economy) forced the RBA to cut rates a few weeks ago.

At least that’s what Phil Anderson reckons. Phil is the editor of Cycles, Trends and Forecasts and Time Trader, his revolutionary new trading product. In a recent note to subscribers, Phil wrote that the RBA’s decision was all about maintaining a decent slope on the yield curve.

The Reserve Bank Board decided to cut official interest rates by 0.25% to 1.75% on Tuesday 3 May.

(Note the date. And the extreme weather in Melbourne.)

Here’s what you need to know. It’s got very little to do with the Australian dollar, nor with the Reserve Bank trying to further stimulate the economy.

It’s to do with the yield curve.

This curve plots the short dated interest rate against long dated bonds.

The curve is said to ‘invert’ when short dated interest rates go higher than long term yields.

Historically, when this happens it portends a slowdown, if left to persist.

With the longer dated yields declining, the Reserve Bank simply cannot allow short dated interest rates to be higher.

They have no choice but to cut. Central banks cannot influence what the longer dated bonds do.

“The market” decides what the long bond rate is via the buyers and the sellers of these bonds and their expectation of future events. Including what they think about future inflation levels.

Central banks can — and do — set the short dated interest rates. At this time, the Reserve Bank of Australia is NOT going to allow the yield curve to invert.

An inverted yield curve (where long term bond yields are higher than short term yields) is one of the surest signs of an impending recession you can get.

Either that, or the market is no longer throwing off the correct signals. Now that a huge pool of savings in Japan and Europe have negative interest rates to look forward to, perhaps their desire to buy anything with a yield abnormally pushes down rates in the US and Australia.

This in turn forces the central banks to act, which puts even more liquidity into the market!

While the yield curve might have panicked the RBA into cutting interest rates, the stock market wasn’t exactly worried about a recession. The chart below shows the ASX 200 Consumer Discretionary index.

Source: Market Analyst

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Last week’s rate cut saw it break out to the highest level since 2008! If there was a recession brewing in Australia, consumer discretionary stocks certainly weren’t showing it.

But since when have central banks ever erred on the side on monetary caution? It is cut first, ask questions later. Or not ask them at all.

With the minutes from the recent RBA meeting due for release tomorrow, the market will be keen to gauge how many more rate cuts are in the pipeline.

Given the pace of China’s slowdown, despite the massive recent stimulus efforts, there could be a few more to come. Over the weekend, data revealed that industrial production, retail sales and fixed asset investment in China all missed expectations for April, reflecting a slowdown over March.

That, along with a weak lead from US stocks, should weigh on our market today.

But you have to ask, what would another interest rate rise really achieve for the economy?

Chris Joye wrote a great article in the Financial Review on Friday about the impotence of monetary policy in generating long term sustainable economic growth. He’s one of the few mainstream business columnists that dares to question the conduct of monetary policy in Australia. That’s probably because he doesn’t work for a bank. As Joye notes:

Despite not being able to forecast the future, the RBA is punting that massively distorting the price of money and ensuing investment decisions in this way (funnelling unprecedented amounts of scarce capital and people into interest rate sensitive sectors like residential and commercial property) will not damage the productive capacity of the economy or savers’ future standards of living.

When informed of the decision, one of the RBA’s staunchest and most respected media supporters bellowed: “They’ve lost the plot.” 

Another long-time fan of Glenn Stevens, who is a multi-billion-dollar hedge fund manager, called me days later saying: “These guys are mad — they’re blowing the mother-of-all property bubbles.”

Joye has it exactly right in saying that central banks are misguided in trying to avoid the effects of the business cycle:

We’ve forgotten that it is the creative destruction that capitalism unleashes — and the corrective downturns that crush bad businesses and create room for better companies to rise in their stead — that is the key to powering productivity and prosperity. The same principle applies in evolutionary biology: adversity breeds stronger species by culling weak members.

The market is simply a reflection of nature. Enabling the weak to survive distorts the natural law of the market. As the saying goes, the road to hell is paved with good intentions.


Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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