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This potential signal from the bond market should cause stock investors to head for the exits

  • The gap between two-year and 10-year Treasurys is the narrowest it has been all year.
  • A flat yield curve is sometimes a sign of an impending slowdown in economic growth.
  • There are a number of reasons this time around is different.
The Marriner S. Eccles Federal Reserve Building in Washington.
Andrew Harrer | Bloomberg | Getty Images
The Marriner S. Eccles Federal Reserve Building in Washington.

While, surprisingly, there are a few cranks left who belong to the "Flat Earth Society," there are an increasing number of individuals on Wall Street who are worried less about the curvature of the Earth than they are about the flattening "curvature" of the bond market.

The "yield curve," a term that describes the gap between short- and long-term Treasury yields, continues to flatten or draw closer together. This is sometimes a sign of an impending slowdown in economic growth.

The spread between two-year Treasury notes and 10-year Treasurys is a mere 57 basis points, the flattest it has been all year.

To some, this can be a worrying sign suggesting a few troubling developments.

Historically, when the Federal Reserve raised interest rates, long-term interest rates tended to rise with them, unless and until the bond market believed the Fed had gone too far and was mistakenly raising rates high enough to tip the economy into a pronounced slowdown, or even recession.

Falling long-term interest rates show that investors believe that, along with growth, inflation will fall also. Thus, they demand less of an "inflation premium" from their bond interest payments.

There could be some justification for this concern.

As Jerome Powell, the nominee to become the next Federal Reserve chairman, noted in his confirmation hearing before the Senate Banking Committee on Tuesday, the Fed is on track to raise interest rates in December by a quarter point.

The Fed is also expected to accelerate the pace at which it shrinks the size of its $4.5 trillion balance sheet, potentially putting further upward pressure on official, and market, interest rates.

The Fed is doing this having achieved half its statutory mandate. The economy appears to be at full, or near full, employment.

However, inflation has been running persistently below the Fed's 2 percent target, with scant signs of a sustained move above that level.

Should the Fed normalize rates too aggressively, without a commensurate rise in inflation, long rates could dip further and possibly fall below short rates.

That condition, known as an "inverted yield curve," has had a very high correlation with slowdowns in the economy. Quite often, it means an impending recession in six to nine months.

However, there could be other explanations for the drop in long rates that are less concerning.

Long-term money managers, those who run pensions, or insurance funds, have to match their assets and liabilities for the long run.

They also have to balance the amount of stocks and bonds they hold in their portfolios in order not to be "overexposed" to any particular asset class.

The S&P 500 is up 17 percent this year, while the Dow Jones industrial average is up almost 20 percent and the Nasdaq has surged almost 30 percent.

Just through sheer appreciation, pension and other long-dated funds have seen the proportion of their stock holdings rise without necessarily increasing their purchases of stocks.

Thus, pension managers, among others, may be rebalancing their portfolios by purchasing 10-year notes to offset their increasing exposure to equities.

In addition, global central banks have stopped selling U.S. dollars and have begun to reaccumulate them.

Notwithstanding the apparent allure of bitcoin, and other cryptocurrencies, the greenback is in great demand around the world.

Indeed, some are arguing that there is a shortage of dollars, and dollar-denominated holdings, among the world's central banks, prompting them to convert their own currencies into U.S. dollars and park the money in a safe spot, like the U.S. Treasury market.

This yield-curve flattening, which has happened before, was more than once identified as a conundrum by former Federal Reserve Chairmen Alan Greenspan and Ben Bernanke.

In Greenspan's time, technological disinflation, and financial deflation, pushed yields lower without implying a slowdown in growth, at least for some time.

Bernanke found that a global savings glut contributed to a similar flattening that, again, pushed money into bonds without indicating an imminent slowdown.

However, there are a couple canaries in the coal mine.

High-yield debt has been selling off for weeks, if not months. Higher-yielding debt reflects not only changes in interest rate policies but also in the future fortunes of heavily indebted corporations.

If a slowdown is coming, the combination of a flattening curve and widening junk bond spreads should serve as a warning about the potential for an economic pullback a few months from now.

This is just a yellow caution sign at the moment.

If the curve should continue to flatten and high-yield spreads suddenly blow out, it will be a flashing red light that should get investors to stop and find the nearest exit sign.