Following the Bond Market's Yield Curve

Having started my career on a bond-trading desk in New York City almost 34 years ago, I have always liked following interest rates. If you have ever read Tom Wolfe's novel, Bonfire of the Vanities, or Michael Lewis' first book, Liar's Poker, you will understand why bonds were far sexier than stocks back then. Because interest rates were so high in the 1970s and ‘80s, that is where most of the trading took place on Wall Street. Today, interest rates are so incredibly low, most investors don't care much about what is happening in the bond market every day, but we do at Northstar.

Instead of watching what bond prices do on an hour-to-hour basis, like we are apt to with stocks, we follow what is known as the yield curve. The yield curve is a graph showing the interest rate or yield on bonds with different maturities. In a normal economic cycle, a two-year bond would yield or pay much less interest than a 10-year bond, which makes sense. Investors should get a higher interest rate for enduring eight more years of interest-rate risk.

However, there are times when the yield curve becomes inverted, which means you can get a higher interest rate or yield on a shorter-term bond than a longer-term bond. For example, the two-year bond would pay you a higher rate of interest than the 10-year bond. This is highly unusual, but incredibly important because when this happens, it has typically signaled a recession. The last three recessions in the United States have occurred when we had an inverted yield curve — in 1990, 2001 and 2007. A recession more often than not, triggers a bear market for stocks, like it did in 1991, 2002 and 2008.

An inverted yield curve only happens when bond traders think the economy is going to get weaker. Bond traders then start to buy bonds with longer maturities in anticipation of the Federal Reserve taking action to stimulate the economy by cutting the Fed Funds Rate. There is a lot more money to be made trading longer-duration bonds once interest rates start to fall than shorter-term duration bonds. Duration measures interest rate risk and since bond prices go up when interest rates go down, you want to own bonds with the longest maturities possible. Once this buying begins in earnest, long-term yields fall and the yield curve will become flatter and eventually gets inverted.

We don't have an inverted yield curve just yet, but the spread between the two-year U.S Treasury bond and 10-year bond is a very low 38 basis points or less than half a percent today. This is certainly a warning signal to investors as to what may lie ahead for the U.S economy and stock market. Indeed, it's hard to see any economic contraction in the near future with the national unemployment rate at only 4.1 percent and the stock market making new highs every week.

However, there is a risk that the new and untested Federal Reserve Chairman Jerome Powell will reduce the $4 trillion in bonds and mortgages the Fed owns too quickly. He could also raise short-term interest rates too fast after all these years of quantitative easing. If he does either of these two things, and the bond market reacts negatively, then the tremendous rally in the stock market could come to a screeching halt.

Since short-term interest have gone up almost 100 basis points in 2017, in our opinion the short end of the yield curve is a lot more attractive to buy. Short-term treasuries provide defense and act as a hedge when the stock market corrects. Investors tend to buy U.S treasuries in times of panic because they are safe and liquid.

Consider also that billions of dollars have flowed into bond exchange traded funds (ETFs) over the last eight years and many of those ETFs are untested in times of real bond market volatility. We have concerns that some exchange traded bond investments could potentially drop more in price on a short-term basis should a liquidity crisis ever occur in the bond market. We saw an example of this in the summer of 2013 when Federal Reserve Chairman Ben Bernanke mentioned the possibility of cutting back on quantitative easing, which became known as the "taper tantrum," and interest rates rose 1 percent rapidly.

With the stock market rally getting a little "long in the tooth" and the unknowns about some bond ETF structures if we have dislocation in the bond market, we think a shift to simple and safe U.S. Treasury bonds is a prudent move to consider.