Wall Street has its own jargon. A language that's all its own. A language that can be difficult to understand at times.
Late last week you may have seen headlines in the Financial Press screaming, that the “Yield Curve Is Inverting.”
Something typical of the Street's jargon, and might be easily dismissed as some sort of traders code, without much meaning to the outside world.
But behind the expression, “the yield curve is inverting” lies a time-tested principle, that we have seen play out over and over again. Something that we should all take note of.
Now, in a normal world, the longer you hold a bond, the more interest it should pay.
For instance, a bond that matures in say 1 year, should have a lower interest rate than a bond that matures in 10 years. That's because the investor who is willing to hold on to a bond for 10 years accepts more risk. Interest rate risk, default risk, and as we're seeing right now, geopolitical risk.
So that's the principal. The longer a bond's maturity, the higher its interest rate, or yield.
Let's introduce another tried and true principal. This one concerns the Federal Reserve. As you know last week the Fed met and elected to raise short-term interest rates by 25 basis points, to 1/2%.
And inevitably, the bond market reacted. Short-term bond interest also rose by roughly 25 basis points. They matched. Short-term rates are set by the fed. And short-term rates are reflected in the bond market.
Now, normally we would expect that the rest of the bond market would react in kind. 25 basis point rises in the 5-year maturities, the 10 years, and so on.
But that decidedly did not happen last week.
Almost completely out the yield curve. That is those bonds with longer and longer maturities started yielding LESS than their shorter cousins.
If you held a 10-year bond you would now receive less interest than the 3-year bond. Same for the 5-year bonds, less than 3 years, 30-year bonds less than 20.
All through the bond maturities, the yield curve, longer maturities are now paying less than shorters.
This is highly unusual. It's unusual enough for one couple of maturities to show an inversion. But to have this number of inversions, and throughout the yield, spectrum is almost unheard of.
So what's going on?
Briefly put, the bond market is telling the Fed, that this latest interest rate hike is not sustainable. There will come a time when the Fed will have to reverse itself and start lowering interest rates again.
Because the economy is that weak.
So the longer bonds, essentially are saying to the Fed: "you can go ahead and raise rates now." But it's only temporary. And "I'm going to keep my interest rate right where it is." Not raise it at all. And just wait until rates have come back down.
How long will this all take?
Well, probably less than 5 years. Because the first couple that is inverted is the 3-year versus 5-year bonds. With the 5-year bonds staying essentially flat, saying you'll all be back down here before their 5-year maturity.
Now, looking at the big picture, this is a very bleak long-term outlook for the economy. Bonds are telling all the world, that we are entering a period of unsustainable growth.
And that try as we might, we are most likely to be mired in this no-growth environment for as long as the bonds can see.
It is a definite vote of “no-confidence” by the bond market for both the Fed and the Administration's Economic Policy.