The Yield Curve

January 9, 2022

The last time this blog highlighted the yield curve, the 10 year treasury was at 11.55%. Today it stands at about 1.77%. This doesn’t seem that much higher of course, but on a percentage basis it is. It’s higher by 15% and that can have a significant impact on cash flow.

For a long time, I have been worried that the US might lose control of their interest rates, and when I first came up with that thesis almost four years ago, I recall the idea being roundly scoffed. Perhaps it was unfounded. Certainly markets today suggest that interest rates are nothing to worry about. The contrarian version of that argument however is that the amount of debt and dollars in the system make the control much more difficult. When the Federal Reserve balance sheet was $1 trillion (against GDP of $14 trillion and Federal debt of $10 trillion), there was plenty of room to maneuver.

Now, post real-estate collapse and post COVID crash, the Federal Reserve balance sheet is about $8.8 trillion (up 880%). GDP has grown to $23 trillion (up 64%), and the debt is at $28.5 trillion (up 285%). Like any borrower, if the ability to repay is constrained, lenders want more security and in this case it will be higher rates.

The over arching direction of interest rates since 1980 has been down. From 14% to 0.25% and markets have responded well. The S&P 500 hit an all time high on January 4th at 4,818 and it is down just 3% from that high. But interest rates have been rising steadily since they bottomed in March of 2020.

If the rise continues to occur in an orderly fashion, then markets will stabilize or decline in an orderly fashion. If rates spike quickly, then markets could collapse faster than many are expecting. Of course there is a chance that markets go up too, but most market predictions for 2022, suggest the upside on the market is very limited. Reuters published a review of six major banks whose targets ranged from 4,400 to 5,300, with the average being 4,950. That is essentially where we were last Tuesday. The point is that all of the risk is to the downside. There is little to be gained (outside of dividends) by remaining in the market, and the risks are rising.

To repeat a refrain from last year, the last time interest rates were this high, they were heading down and the S&P was at 3,300. This time, all indications are that interest rates are rising and clearly 3,300 is about 30% below where we are now.

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