The Yield Curve Yields

Brexit? What Brexit?

The S&P 500 is an index of the 500 largest capitalized publically traded companies in the US. The Standard and Poors (S&P) 500 index is the measure which most academics use as a baseline when studying stock market activity.

Here are some interesting S&P 500 numbers from recent days:

Here are some interesting S&P 500 numbers from recent days:

Brexit was a political referendum. While its impact will play out over the next several years, it had virtually no short-term impact on the market, other than scaring the pants off most investors and thereby creating a good buying opportunity.

Meanwhile, the media ignores the bond market which is screaming all kinds of projections.

The bond market is three or four times larger than the stock market. Bonds are debt securities. The most typical bond structure for bonds traded in the marketplace is a promise to pay two things: stated interest periodically and the face value (principle) at maturity. The most important relationship to understand about these promises is that the value of the bond at any point in time moves inversely to the interest rate (yield).

To illustrate this point, suppose that a $1,000 debt is due in 5 years. The debtor (person who owes the debt) has two choices to meet this debt obligation: a) put aside $621 today in an account that will grow at 10% per year for the five-year period or b) put aside $784 in an account that will grow at 5% per year for the five-year period. Note that the value of the debt (the amount which must be set aside) today is lower the higher the interest rate: $621 growing at 10% is lower than $784 growing at 5%.

Yield Curve

The Yield Curve (there is only one such beast) is a plot of the maturities of US Government debt securities versus time.

Since the US Treasury securities cannot default because the government can always print more money to make interest and principal payments, US Treasury securities are considered the safest securities on the whole planet. All other debt securities, both foreign and domestic, are priced in relation to US Treasury securities.

Here is the yield curve as of the close of markets on July 1, 2016, as provided by Morningstar, an independent securities research group. The dark line is July 1, 2016; the lighter line is one year ago.

Here is the yield curve as of the close of markets on July 1, 2016

The “normal” Yield Curve tilts upward to the right reflecting the fact that US Treasury security holders require a higher return to compensate for the risks of holding the securities for the longer term. The risks include such things as the risk that interest rates will change over time and the risk of inflation eating away at the purchasing power of the principal that will be returned at maturity some years hence.

The US Federal Reserve (aka “the Fed”) can only influence the interest rate at the shortest maturities by manipulating the short-term interest rate (aka discount rate) at which banks can borrow overnight from the US Federal Reserve to meet their capital reserve requirements. Thus at the left side of the curve, the current rate is higher than a year ago reflecting the Fed’s recent one-quarter point increase in the discount rate.

The important part of the curve is at the right end – the longer maturities. Note that the long-term interest rates now are less than a year ago. That is not what the Fed had in mind. By raising the short-term rate, the Fed was attempting to cause the Yield Curve to shift upward everywhere. By increasing rates, the Fed was attempting to “slow” the economy down ahead of what the Fed perceived as building inflationary pressure as the economy grows.

In the 12th century, the English King Canute ordered the tides not to rise and wet his feet. The good King Canute was trying to show the futility of trying to stop natural processes.

The Fed is learning that lesson the hard way. As the world markets confront greater and greater uncertainty (aka terrorism, dictatorship, economic insecurity, autocratic rule), investors are seeking to buy the safest securities – US Treasuries. An increase in the demand for any good pushes up the price of those goods in accordance with the Law of Supply and Demand (Economics 101). Since bond prices move inversely to interest rates, the increase in demand for US Treasury securities causes the prices of US Treasury securities to rise and the interest rates on those same US Treasury securities to fall.

Thus, it would appear that the Fed is running out of ammunition as it attempts to move interest rates higher.

Watch this play out in the days, months, and years ahead. It is unlikely that the Fed can move interest rates which mean they will continue to remain low. That means, in turn, that bonds (fixed income) investment returns will most likely continue to be low for the foreseeable future.

In spite of the best efforts of the US and world politicians to be politically correct and to demean the US at every chance, world investors are very politically incorrect and recognize that US Treasury securities are the safest place to be. The Yield Curve has yielded to current events as all the hiccups around the world work to keep US interest rates low.

Riley’s Views

Riley, the Golden Retriever

I asked Riley, the Golden Retriever with whom I share my office, what she thought of the Brexit. She tilted her head quizzically and then limped toward the cabinet where her food is kept. “Brexit not biscuit” I explained as I gave her a cookie. I am not surprised at her confusion as the whole topic befuddles a lot of people.

I then asked Riley about the Yield Curve and how the Fed is getting nowhere trying to stimulate growth in the economy. She looked at me and then turned her head toward her left hip which has begun giving her trouble due to arthritis and a bit of hip dysplasia (hence the limp). You are right, Riley. The economy is limping along with little prospects of significant improvement. Unfortunately, we just have to learn to live with it and do the best we can. Not great news but we can still get about.

There is a national election coming in the fall which might be shaping up in part as the American version of the Brexit. Do you need to update your voter registration? You are not going to want to sit this one out.

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