Will The Inverted Yield Curve Drive The Market Lower?

Hi Dave,

As we all know, the stock market is at unreasonable levels by nearly almost any measure. Does the flattening/steepening yield curve hold out the possibility of being the initial catalyst for lower levels?

Thanks,

Michael R. – Vashon Island WA

Michael,

Thanks for the question – a really good one.

First off however, your location. Vashon Island is really amazing, a great place to live/visit. It is also home to one of our (myself & Christine’s) favorite wineries – Andrew Will Winery. For readers who are wine enthusiasts I encourage you to check their wines out.

While on the topic of wine. I had a meeting Friday afternoon in Hood River Oregon – yet another jewel here in the Pacific Northwest. While there I popped over to Jacob Williams Winery. Give the 2013 Barbera a try – really tasty.

Lastly, the drive back to Bend was not too shabby in terms of the scenery with Mt. hood majestically before me.

Oh….right, your question.

I would agree that the flattening/slight steepening of the yield curve presents some headwinds for the economy and banking sector at large.

  • 3-month Treasury bill yields have risen to 0.92%, from less than 0.20% in the fall of 2016.
  • Despite the Atlanta Fed upgrading their forecast for GDP to 3.7%, the bond market puts less than a 50% chance of 2 more hikes this year.
    • To me the bond market is usually the better forecaster. As such, the bond market suggests a ‘less robust’ economy going forward
  • Upward momentum in Treasury yields has been confined to the very front end of the curve.  It costs almost as much to procure unsecured funding for three months on the interbank market as it does for Uncle Sam to borrow for twenty-four months (about 1.29%).*

*Source: Grant’s

Given that banks derive a decent amount of their earnings from the spread between short term borrowing and long term lending, this yield curve flattening is not good.

Add to that an environment that is looking less kind to lending.

Failed consumer loans also dinged banks’ balance sheets. Banks charged off $11.5 billion of loans in total in the first quarter, an increase of 13.4%. Net credit card charge-offs rose 22.1%, while auto loan charge-offs increased nearly 28%. Charge-offs of “other loans to individuals” increased a whopping 66.4%. 

Source: CFO.com

So….I do not exactly have a lot of confidence at being passively long the market (i.e. buy and hold, indexing etc etc) but I have felt like that for some time now. Nonetheless, the reward/risk for being long equities is simply not there unless of course you are making tactical bullish trades from time to time. That is something I continue to do….for now.

Have a question for me? Just ask.

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