The stock market sits close to a record high while the spread between the 10-yr note yield and the 2-year note yield is near a five-year low.
The stock market sits close to a record high, yet the latest Flow Show report from Bank of America Merrill Lynch indicated government bonds and Treasuries saw their biggest inflow in 19 weeks, according to Reuters.
The stock market sits close to a record high, and, well, things just don't seem right given the commensurate strength in the Treasury market.
Paradoxically, the strength at the back end of the Treasury yield curve may very well be the source of strength for the stock market as the persistence of low rates continues to promote the relative value argument for stocks. It's a defensible position, assuming the strength in the Treasury market at the back end of the curve isn't the canary in the coal mine.
Laudable and Audible
The performance of the stock market has been laudable while the narrowing spread between the 10-year note and the 2-year note has been audible, resonating as a possible warning sign that growth isn't going to be as robust as some market participants hope it will be.
To get a better understanding of the narrowing spread, one must first understand that it has been driven more by the 10-year note yield moving down than it has been by the 2-year note yield moving up. To that end, the yield on the 10-year note has declined 26 basis points since the end of 2016 while the yield on the 2-year note has risen nine basis points.
This is an important distinction in the context of thinking about the Federal Reserve's monetary policy. That policy has been accented of late with a tightening bias, including two rate hikes since December and the thinking that the Federal Reserve will start the process of normalizing its balance sheet before the end of the year.
For good measure, it is viewed by the market as a near certainty that the target range for the federal funds rate will be raised again at the Federal Open Market Committee's June 13-14 meeting.
The Federal Reserve can control short-term rates, but it can't effectively control long-term rates. Hence, a flattening yield curve driven by the front end moving up and the back end moving down implies that there is concern the Federal Reserve is going to make a policy mistake.
The mistake in this instance would be tightening too much at a time when the economy isn't yet strong enough to handle it. In other words, there is a fear that the Federal Reserve is going to move too much, too soon, and choke off economic recovery efforts.
Fading inflation expectations seen in the five-year, five-year forward breakeven rate help corroborate that mindset. Moreover, a slowdown in lending activity, a downturn in the seasonally adjusted annual rate of auto sales, and the PowerShares DB Commodity Index Tracking Fund (DBC) sitting near a 52-week low have also added to the concerns about a potential policy mistake being made.
More To It
To be fair, the Federal Reserve doesn't deserve all of the credit for the flattening of the yield curve. There have been multiple contributing factors in the trading mix.
- Waning confidence in the Trump Administration achieving fiscal stimulus measures (i.e. tax reform and an infrastructure spending plan) before the end of the year
- Increased worries about political risk/uncertainty at home and abroad
- Stepped-up concerns about a geopolitical conflict happening
- Reports of renewed buying activity by China
- The continued appeal of interest-rate differential trades given the persistence of extremely low (and/or negative) bond yields in Japan and Europe
- Emerging chatter that the debt ceiling will need to be increased sooner than expected and that there is disagreement in the House GOP about passing a "clean" debt ceiling increase
- Underlying concerns about the stock market being due for a correction and the use of Treasuries as a hedge against a possible downturn
- The pursuit of a safe return on capital that remains in favor by investors in, or close to, retirement; and
- The expectation that inflation will be held in check
What It All Means
It is hard to determine what it all means at the moment.
The flattening yield curve is inconsistent with the argument that the economy is destined to produce much stronger growth in the back half of the year. It is important to note, too, that the yield curve hasn't inverted either, which is often equated with a recession.
Per chance, the flattening yield curve is simply signalling an extended period of low growth and low inflation, which is a coupling that has certainly proved to be a supportive backdrop for equities. In that regard, one could argue that the strength in both the stock and Treasury markets is more consistent than it is inconsistent.
Future data, which will ultimately capture the impact of political developments, geopolitical happenings, and general economic activity not known today, will provide some telling answers as to whether one market is right and the other is wrong in what it appears to be signalling.
For now, neither has indisputable bragging rights, which means the canary is still alive in the coal mine with wings showing shades of grey.