More and more attention is being placed on the yield curve now that the spread between 2-year and 10-year rates has narrowed to below 30 basis points. The St. Louis Fed chart showing the correlation between recessions (shaded areas) and the yield spread going negative is now seared into Wall Street's collective hive mind. As of this writing, 7 articles on the yield curve have been published in the last week on Seeking Alpha alone (Here's to 8!).
But there's a problem with this coverage. As much press as the yield curve has been getting lately, all the focus has been on what happens to the economy and stocks when the spread breaks below zero. Bulls believe nothing big will happen, and it's all much ado about nothing. Bears believe the collapsing yield spread spells doom for stocks and signals an imminent recession.
Here I'd like to focus here on the opposite question. Assuming we will break the zero barrier soon, though who knows exactly when, what happens when the yield spread goes back up as it always has?
The reasons why I believe this is a much more interesting question and conundrum are as follows. First, the fact that everyone is focusing on the falling yield curve makes me tend to believe it might be a red herring. Either that or everyone could actually start selling once it gets close to zero in a self-fulfilling bear prophecy. Truthfully, there is so much attention focused on it that I have no idea what will happen when it hits zero. But even the yield curve isn't a red herring, and let's assume for a moment that the yield curve going negative will accurately predict a recession and possibly a new bear market this time as it has in the past; that might not be the biggest problem here.
Why not? Consider what has to happen to interest rates across the curve for the 10Y-2Y yield spread to head back to its positive peak. There are three general options here, each more problematic than the next:
- Short-term rates will have to go down and long-term rates rise slightly (least problematic).
- Or if short-term rates stay stable, long-term interest rates would have to about double (more problematic).
- And finally, if short-term rates drift upward, long-term rates will have to go much, much higher to push the yield spread to its past peaks (serious problem).
The other option, let's call it option 4, is that rates don't move and the yield spread just stays at around 0 for a prolonged period of time, which has never happened before, and which would have serious unknown consequences for money creation and the global economy.
Discounting option 4, for the following reasons, I think the most likely scenario is actually option 3, the serious problem.
There is already some evidence that the Federal Reserve is having some trouble keeping short-term rates down. I have covered this in different places from different angles, and I'll reiterate here from yet another one. The overnight Federal funds rate, the actual rate that the Fed either hikes or lowers and the rate at which banks lend money to one another to satisfy overnight reserve requirements, has been creeping closer and closer to the upper boundary since April, two rate hikes ago. Back in April, the effective fed funds rate was 1.7%, and the upper boundary back then was 1.75%. Now, the effective rate is 1.91%, down from 1.92% on June 26, but still within 9 basis points of the upper boundary of 2%.
This overnight interest rate creep has made megabank analysts worried that the Fed may be forced to stop shrinking its balance sheet sooner than initially thought. Bloomberg covered the issue on July 3rd, the New York Times on June 15th, FT on June 14th, and CNBC and Reuters have also weighed in on this. All articles make the same basic attempt to explain the Fed's recent cryptic move to lower the spread between interest on excess reserves and the effective Fed funds rate by 5 basis points. Basically, jargon aside it's an attempt to encourage banks to loan out excess reserves so as to alleviate upward pressure on the overnight rate so that it doesn't break through the upper boundary, which would be seriously embarrassing for the Fed and could have grave repercussions globally if the Fed is thought to have lost control over monetary policy.
The commonly held belief in all these reports is that competition from the Treasury in the short-term money market is creating a dearth of liquidity for short-term borrowing, pushing the overnight rate higher a little too close to the upper boundary for comfort. The other explanation repeated by these sources is that the $1.8 trillion in excess reserves still recorded in the banking system is actually misleading, because according to Morgan Stanley, cited by Reuters, 90% of these funds are controlled by only 5% of banks. That means 95% of banks in the country, or about 5,700 banks, have only about $94B in excess reserves between them that can be loaned out in a pinch. That's only about $16.5M in excess reserves on average for the vast majority of banks in the country, all of which must satisfy reserve requirements at the end of each day. Combine that with the Treasury sucking liquidity out at record rates to fund record Federal budget deficits and you have the recipe for strong upward pressure on short-term interest rates.
I also happen to believe that rising price inflation is playing a major role in the upward pressure on short-term rates in addition to those other factors.
My point though is this. Given rising inflation, rising Federal budget deficits vacuuming out liquidity and the surprising lack of excess reserves to loan out to begin with at this point, if Morgan Stanley is correct, upward pressure on short-term rates is intense. Pushing short-term rates back down to zero from here would require massive amounts of new money printing to cancel out and overcome the existing upward pressure, which could put terminal stress on the dollar.
And that's why the yield spread heading back up is the real problem here. There's already intense pressure on short-term rates forcing them higher. That's why the yield curve is falling in the first place. Now that pressure is showing up in the overnight rate, putting pressure on the Fed itself. Even assuming 2Y yields stay where they are at around 2.5% currently, which is unlikely given the pressure on the short end of the curve, the 10Y-2Y spread having maxed out at an average 2.7 during its sine-wave cycles since 1992 means that 10Y rates would have to head to about 5.2% on the next wave up. If short-term rates head back up to historical norms of around 4%, 10Y yield would have to be around 6.5%.
I don't think the economy can handle such rates given the amount of debt weighing it down.
But forget the economy and forget stocks. It's the dollar that's really in trouble here if and when the yield spread heads back up, because the Fed will have to print much more to fight them back down again so the national debt can be serviced. None of this looks good, and all eyes should be on whether the Fed can keep the overnight rate in range. It may be able to for a while longer, but eventually either it will break out to the upside and seriously embarrass the Fed or the Fed will have to preempt the upward pressure by hiking short-term rates much faster than mainstream money market analysts currently believe is even on the radar.
The conclusion? The Fed is being boxed in, and it doesn't even see what's happening. It's going to be a choice between the dollar and the economy, and the yield curve may just be the hourglass.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.