One of the things that I find really troublesome is the Yield Curve, or more specifically, what the Federal Reserve will do to stimulate the economy when we get to the next recession and stock market correction.
The Yield Curve is a line graph that plots the span of interest rates from overnight rates to 30-year bond rates on a single day. In a normal situation, short-term rates are lower than long-term rates and the line graph has an upward slope to it. But there are times, in particular when you are at a recession, that short-term rates are higher than long-term rates – this is called an inverted yield curve. This situation comes from investors fleeing the stock market due to the risk of corporate earnings falling in the recession. The investors are reinvesting their money in the safety of bonds, driving the longer term rates down since there is so much demand. The inversion can also be aided by a Federal Reserve that doesn’t cut interest rates fast enough to avoid the recession.
In the graph above from the peak of the stock market in 2000 (the red vertical line) you can see the yield curve on that specific day (the red downward sloping line) was inverted. The recession was upon us and the stock market started its long journey down as corporate earnings were less than expected.
Fast forward to the bottom of the stock market in 2003 (again the red vertical line) and you can see that the Federal Reserve had cut short-term interest rates from roughly 6% to 1% in order stimulate the economy. The yield curve resumed its normal shape and companies started to experience increased earnings coming out of the recession, those earnings increases translated into a bull market for stocks.
Fast forward to the top of the market in 2007 and you can see that we again have an inverted yield curve. Shortly after this date, the recession takes hold and corporate earnings begin to fall sending the stock market down decisively (this was a lack-of-liquidity driven market crash as much as falling corporate earnings). To combat the recession and to add liquidity to the financial system, the Federal Reserve cut interest rates again.
You can see that at the bottom of the market in 2009, we again have a normal yield curve with short-term rates cut by the Federal Reserve from just under 5% to just above 0%. Those near 0% rates fueled a rally in the stock market that ran to last May’s highs. Unfortunately, corporate earnings have started to fall again and there is talk of another recession coming our way.
This is the yield curve today. You can see that it is still a normal yield curve, but that it is noticeably flatter than the one above (this could possibly presage an inverted yield curve – but it would be difficult to get long-term rates near zero, but anything can happen in this economy where we have no past history to learn from). You can also see that the Federal Reserve has kept short-term rates at the near 0% level. The question we should all want an answer to is what will the Fed do when we get to the next recession if it cannot lower interest rates since they never raised them as would be normal during an economic cycle.
There is a lot of speculation that our Federal Reserve will follow the European Central Bank in two ways: negative interest rates and purchasing corporate bonds in a new round of quantitative easing.
We haven’t talked about QE in a while here on the blog because the Fed ended that practice a couple years ago – QE is where the Federal Reserve prints money to flood the economy with liquidity by buying government bonds.
Both of these actions, if the Fed were to follow the ECB’s lead, would be unprecedented. Much of the economic stagnation we currently have comes from the 0% rates – consumers and businesses have loaded up on debt to record levels given the low rates.
Consumers have incomes that have not kept up with their debt fueled spending and they are not the catalyst for economic activity that they once were.
Corporations have used the debt to buy back their outstanding shares of stock, a financial trick that makes their earnings per share appear to go up simply because there are fewer shares to spread the earnings over. The side effect of borrowing to buy back shares is that reinvestment into property, plant and equipment as well as research and development has been curtailed, adding to our economic stagnation.
What unintended harm can negative rates or QE for corporate bonds have? I don’t know but it will likely continue to provide the wrong incentives for consumers and corporations while not doing anything to stimulate the economy. This is our yield curve curve ball, or with a nod to Wheel of Fortune, our yield curve ball.