The equity markets sold off today. All of the major indexes were off about 1%. North Korea’s gift to the world this past weekend – a test of a new Hydrogen Bomb that registered 6.3 on the Richter scale – was one reason for the sell-off. Another reason was the flattening of the Yield Curve. Major US bank stocks sold off big-time as a result of the Yield Curve flattening. Some banks stocks were down 2% or more.
The Yield Curve is a graphic depiction of US Treasury yields plotted against their time to maturity. (When I say graphic depiction, don’t think blood and gore – think about a graph). Usually, the Yield Curve is upward-sloping. This makes sense if you think about it. You would want a long-term Treasury (say 10 years to maturity) to yield more than a short-term Treasury (say 3 months). If you are investing in US Treasuries, you would want a higher yield for locking your money up for 10 years than for 3 months.
Prior to President Trump’s November 2016 election, the yield curve was relatively flat. For instance, on January 4, 2016, the 3 Month T-Bill yielded 0.22%, and the 10 Year T-Note yielded 2.24%, which is a difference of 2.02%, or “202 basis points” in bond trader parlance. (One basis point equals 0.01%). Remember the headlines from this period? Negative interest rates in Europe? That means banks charge you for lending them money. Bass-ackwards.
Trump’s election was said to be inflationary by the financial punditry at the time. Greater economic growth meant greater inflation, it was thought by the Keynesian economists who govern the Federal Reserve Bank. The Fed raised short-term interest rates. (To be fair, the Fed had started their interest rate hikes prior to Trump). All US Treasury rates went up. At their highest point, which was on 12/15/16, the 10 Year T-Note yielded 2.60%. The 3-month T-Bill was at 0.51% on the same day, which equated to a spread of 209 basis points. Similar spread to 1/4/16, but still relatively flat.
By the way: A short-term Treasury (say less than a year) is called a T-Bill; a middle-term Treasury (say 2-10 years) is called a T-Note, and a longer-term Treasury is called a Bond. More bond-trader parlance. Just like in horse racing: A male horse less than 5 years old is a colt, and a male horse 5 years old or older is called a, wait for it, a horse.
Today – Flat
At the close of trading today (9/5/17), the 10 Year closed at 2.07% and the 3-month T-Bill closed at 1.03%, a spread of only 104 basis points. Considerably flatter than the 209 basis point difference on 12/15/16. Why? The Fed has bumped up short-term rates, while at the same time the “inflationary” Trump agenda has met roadblocks. The Norks are exploding big bombs, which causes investors to seek the safety of longer-term US Treasuries, which causes their yields to go down.
The flattening of the Yield Curve is not a good sign. It means Treasury investors think there may be more short-term danger than long-term danger. What if things go truly bass-ackwards and the Yield Curve inverts? Meaning short-term rates are higher than long-term rates? Almost always, when the Yield Curve inverts, a general economic recession ensues. Fortunately, it doesn’t happen too often. Also, fortunately, flat is not the same as inverted.
A flat Yield Curve is bad for banks. A lot of bank lending, including home mortgage lending, is priced off of the 10 Year T-Note. Likewise, a lot of bank borrowing (i.e., customer deposits) is priced based on short-term Treasuries – including but not exclusively the 3-month T-Bill. When the Yield Curve flattens, banks’ spreads ( the difference between lending and borrowing rates) also flatten, and banks don’t make as much money. Investors in bank stocks come to realize this narrowing spread in aha moments like today, and they head for the hills en masse.
I think there is a safety premium now on the long end of the Treasury market. I don’t think the North Korea threat is a great one because I don’t think North Korea has the ability to strike the US or any of its allies, nor does North Korea desire to strike the US. They are just making a lot of noise. I don’t think economic expansion = inflation. Maybe investors in long-term Treasuries realize this as well. Unless there is some sort of outside shock to the economic system, I think the Fed will continue to raise short term rates, which may put more pressure on the Yield Curve. Banks will figure out a way to earn money. The banking system is in much better shape than it was 10 years ago due to increased equity capital on their balance sheets.
I have previously written about taking a chill pill. Same applies here.