How low can you go? That's an oft-repeated phrase in a limbo contest, yet it's creeping up more and more these days with respect to the yield curve.
We've been harping on the narrowing spread between the 2-yr note yield and the 10-yr note yield for several weeks because it has emerged as a perplexing development at a time when the stock market has been immersed in optimism about accelerating economic growth.
There is a lot of innuendo wrapped up in the narrowing spread. The most popular innuendo is that it is a harbinger of slower economic growth.
That slowdown concern has bubbled to the surface in recent days with several developments coalescing to give the newfangled narrative some life:
- The IEA cut its oil demand growth forecast for 2017 and 2018
- Copper prices have declined 5.3% over the last month
- China reported weaker than expected retail sales, fixed asset investment, and industrial production data for October
- The Senate GOP has fueled doubts about the passage of a tax reform plan with provisions in its tax bill to repeal the individual health care mandate and to make individual tax cuts temporary (expiring in 2025) while making the corporate tax cut permanent
- High-yield spreads have been widening, albeit from a very tight level that has been near historic lows
- The US Dollar Index has weakened
This coalition of headlines has provided some reasonable excuses for equity investors to take some money off the table after a record-setting run by the major indices.
It is still too early, though, to be convinced that the stock market is making a 180-degree turn with its economic outlook. It can't be so long as the prospect of a tax reform plan being passed remains alive -- which it does.
The stock market, however, may become more convinced if incoming data turns weaker and the Federal Reserve presses ahead with a rate hike at its December meeting.
With the huge jump in the 2-yr note yield since mid-September to 1.71% (a nine-year high), one could reasonably assert that the market has priced in a December rate hike. The 10-yr note yield, however, has been slower to respond to the so-called reflation trade; hence, the spread between the two has narrowed to just 64 basis points from 125 basis points at the start of the year.
What can be gleaned from this?
It's hard to say, but the narrower the spread gets, the greater the concern will grow that the Federal Reserve is on course for making a policy mistake that chokes off the economic recovery effort.
If so, the flattening curve today won't be so perplexing in hindsight.
(Editor's note: The next installment of The Big Picture will be posted on Friday, December 1)