There is nothing like uncertainty and speculation to prove everyone wrong! What am I talking about? The bond market is not playing along with the Fed’s statements about a stronger economy. In short, the Fed needs to watch the bond yield curve before any more interest rate hikes are considered.

Copyright: rungaroon / 123RF Stock Photo

To understand why let’s go back about a month to the last Fed meeting when the committee raised the Fed funds rate. This was the third hike in about 15 months, and it only raised the rate to 0.75%. A normalized interest rate policy has this rate around 3%, so for all intents and purposes, the Fed is still accommodating the markets with low-interest rates.

Recently, Fed governors have said the economy is stronger and can absorb rate hikes. This is due mostly to strength in the jobs and housing markets, which, along with a few other areas, are pointing to higher GDP. There are some weak areas of course – consumer, industrial production, and commodities – and so far, GDP for Q1 appears weak. A snapback is quite possible, but there is nothing in the data pointing in that direction.

Why the bond yield curve matters

And that brings us to the bond market, which is not going along with the “stronger economy” thesis. In fact, it has gone in the other direction and completely dismissed the Fed’s notion of a stronger economy. How do we know this? The long end of the curve – which is controlled by the bond market – is actually much lower than we would like to see in a growth situation.

Remember the worries over rising rates? Just after the Fed hiked rates, analysts expressed concern that the 10 yr bond would move above 2.6%. Now the worry is a break of 2%. With rates hovering near 2% on the 10 yr, it means the yield curve is flatter. This affects banks directly, as the lucrative “net interest margin” has been nonexistent for years.

If the bond yield curve continues to flatten or even inverts, the message is clear: the economy is in trouble. The Fed may have to halt or even retreat from those recent rate hikes.

To complicate matters, we are dealing with a lot of uncertainty and turmoil around the world. The safest haven is US treasuries. However, if yields drop too low then we are looking at another alternative – stocks, in which case bonds would sell off one more time.

We’ll see if that materializes on the horizon as we enter a rather dour calendar period for stocks when conventional wisdom tells us to “sell in May and go away.” Til then, keep your eyes on the bond yield curve.