When The Bond And Stock Markets Disagree

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The jobs report was surprisingly strong, with 287,000 new jobs created in June, but the three month average was in line with much of the recovery so far.

The stock market rallied, but longer term bonds held steady. Meanwhile, short-term yields rose in anticipation of potential Fed tightening earlier than once thought.

What is the meaning of a flattening yield curve? Is it a slowing economy – or perhaps robust foreign demand, given Brexit and negative yields in Europe?

The impact of a flattening yield curve might be felt by banks, which see their net interest margin shrink.

Narrow net interest margins may be transmitted to the economy by any changes to lending activities in response – and a flatter yield curve may influence Fed policy.

The jobs report and the markets' reactions

The above-consensus increase in payrolls of 287,000 reported by the Bureau of Labor Statistics Friday provoked an interesting reaction in the markets: stocks rallied strongly, while the yield curve flattened, in data from Bloomberg. A flattening yield curve is an event we'd more likely see when worries about the economy prevail. But Friday's jobs report offered no suggestion that was the case. If anything, the jobs report should have conveyed that the May jobs number of just 11,000 new jobs created (revised lower from a previously-reported 38,000 increase) was perhaps a fluke. One might rationally ask, what is going on?

Well, there are a few considerations - and a few knock-on effects as well - for us to examine. Our focus isn't so much on the jobs report per se, but rather what is the driving force behind the flattening yield curve. We'll begin by looking at whether the jobs report was really all that strong by looking at the three month average since the recession ended.

From this graph, it is easy to see that job gains over the past few quarters have actually decelerated a bit, but are within the range of job gains since the economy began consistently been adding jobs in late 2010. And average hourly earnings ticked up by 2 cents for all employees, according to the BLS. Perhaps bond investors were less swayed by the strong one-month gains and focused on still-modest wage gains in June and hiring that, over time, hasn't deviated much from trend.

The role of foreign investors and Brexit concerns

But really, though, the story isn't just about the jobs market, or even the U.S. economy, though those are factors, of course. From trading on Friday, it seemed buyers snapped up Treasuries whenever prices dipped. Low yields in other developed nations - the yield on the 10-year German bund was trading at a negative 19 basis points on Friday, according to Dow Jones data - propel investors abroad into better-yielding U.S. bonds. Fears of what may transpire following Brexit are a factor, too. These alone are reasons to keep a lid on U.S. bond yields - even though those events beyond our shores may arguably have limited direct impact on the U.S. economy.

The flattening yield curve

But what are the knock-on effects of lower yields? I discussed whether low yields would boost economic growth in a recent post, but there are other ramifications as well, transmitted through the financial sector. One of those begins with the flattening yield curve, as seen in the nearby graph. This chart measures the difference between 10-year Treasury yields and 2-year Treasury yields: the smaller the difference, the flatter the yield curve is.

For a longer history, consider the pattern seen of a flattening yield curve prior to economic slowdowns. However, a flattening yield curve in the current environment hasn't been all that sudden - it's persisted for years, a trend accelerated when central banks abroad began their asset purchase programs.

At the same time, though, the Fed may have room to argue for a rate hike later this year. Fed-funds futures on Friday indicated a 24% likelihood of a rate increase by the Fed's December meeting, compared with 19% before the jobs report, according to CME Group. These are compiled by traders' and investors' bets on the direction of Fed policy. That helped lift the yield on shorter-term instruments, even as demand for Treasuries of longer maturities pushed down yields. Presto, the yield curve flattened, potentially signaling a misleading, or at least ambiguous, signal of how economic conditions may transpire.

The effects on bank profit margins

But the story doesn't end there. Many banks, particularly those with longer-term loans on their books, such as mortgages or some business loans, see their net interest margin, or the difference between what they earn on loans and what they pay on deposits, shrink. A shrinking net interest margin can pressure banks' profits, but again, this isn't a new development, as seen in the nearby graph.

A question might be whether banks, whose profits may be under pressure from a flattening yield curve, may make more higher-interest loans to lower-tiered customers, where they may have greater margins. On the other hand, might banks constrict lending as they focus on assets with lower risk of defaults, if they are concerned about maintaining enough reserves to cover higher-risk loans?

The answer to that question may play some role in influencing the direction of the economy going forward, at least in some part. After all, the flow of credit to businesses and consumers is vital to an expanding economy.


In sum, the strength of the jobs market could result in a Fed that is not on hold as long as some investors had recently thought, driving up yields on the short end of the curve, even as longer rates are held down by foreign investor demand for Treasuries. If the yield curve flattens more based on this thesis, it could have ramifications beyond the control of the Fed. And for that reason, the paradox is, the more likely short-term bond investors think the Fed will tighten - and the more the yield curve flattens - the greater the rationale is for the Fed to stay on hold longer.


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