In financial markets, as in most fields, data is objective but the interpretation of said data is highly subjective. Numbers are immutable, but the conclusions we draw from them can vary wildly. That is especially true when it comes to data dictated by price. Price is an expression of a group of people’s interpretations of other information, and as such is itself subjective.
When we attempt to interpret price-driven numbers we are trying to read the minds of the traders and investors who set the price, and their motivations can change over time.
I apologize if all that sounds a little too philosophical but thinking along those lines has recently led to me questioning my own interpretation of recent changes in the yield curve, changes that have a bearing on every traded market in America.
To understand why that is significant you must first understand what the yield curve is and why it matters. Government bonds, including the U.S. Treasuries referred to here, are generally talked about in terms of their “yield” rather than price. The yield of a bond (or, for the pedants, a note, bill or any other fixed income security) is the annualized return an investor will receive if they buy it at its current price.
That yield varies according to how long the bond has until it matures. In general, if people are going to tie up money for a longer period, they demand a better annual return than for short-dated paper. Therefore, if you create a chart that plots the yield on the vertical axis against the time to maturity on the horizontal, you naturally get an upward sloping curve.
Changes in the steepness and shape of that curve come as expectations for future interest rates change, with those expectations being traditionally seen as an expression of the market’s expectations for economic growth.
The assumption is that the Fed will raise rates in periods of strong growth and lower them when times get tough. On that basis, the more interest rates are expected to climb in the future (or the steeper the yield curve), the better the economic outlook.
That is the relationship I was taught decades ago as a young trader, and it is still the conventional wisdom today. However, a case can be made that that interpretation is no longer valid.
When Ben Bernanke’s Fed embarked on policies such as near zero interest rates and QE in response to the 2008 recession, those policies were new and untried. How you view changes in the yield curve today depends on how fundamentally you think they changed the game and how long you believe their effects will last.
I would argue that they have shifted expectations to such an extent that every conventional wisdom about the yield curve should be re-examined.
There has recently been a lot of concern, concern that I have shared until now, that the yield curve has been flattening. As short-term rates have climbed in response to rate hikes by the Fed long-term rates have essentially remained unchanged, and even fallen at times.
The traditional interpretation of that move is that it signals a heightened risk of recession soon, but if the Fed’s actions over the last decade have really led to fundamental changes in conditions, that doesn’t have to be true.
It could be that traders believe that there really is a “new normal,” where the range of future interest rates is narrowing as the Fed better understands how to smooth out economic cycles. That would certainly help to explain why the stock market keeps hitting new highs, even as curve flattening continues.
Remember, what we are trying to do here is determine how others are interpreting data. That doesn’t mean that you have to buy into the infallibility and omniscience of the Fed or of economists to rethink the recent changes in the yield curve. You just have to believe that the central bank is better equipped to handle both downturns and upturns in the future. On that basis, a flatter yield curve is anything but a negative sign, it is a sign of optimism.