Our first indicator of economic health, and possibly stock market returns, is the spread between the 10 Year US Government Bond, and the 2 Year Governmet Note. According to the graph above from the St. Louis Federal Reserve, whenever this spread goes negative, we eventually go into a recession (faded area). Right now the US economy has avoided that fate as the spread stands at 0.86. Many pundits make a point to say that bull markets don’t die of old age; this implies that the Federal Reserve’s is the hand that forces this fate, or, by chance, some other exogenous shock is the cause.
So why has this metric proved so useful in this regard? When you think about it, economic expansion is generally caused by an expansion of credit. What technically tipped off the Great Recession? A freeze in liquidity. Who provides liquidity? Banks provide liquidity. When they have to pay out a short-term rate (2Yr) to depositors and receive interest on longer-term (10Yr) loans, they (usually) make money. This is called the Net Interest Margin, commonly abbreviated as NIM.
The banks are at the mercy of the Fed, though, because they set the baseline for short-term rates, and why would a bank create credit expressly for the purpose of losing money? They wouldn’t. A negative net interest margin occurs when a bank pays out more to it’s short-term depositors than it receives for riskier, longer-term lending. This is why all this talk about the Fed has generated the attention of market watchers.
If the Fed decides to raise rates at anything more than a glacial pace, creators of credit could suffer. The total return for the XLF Financial Sector ETF have been 37% for the past 12 months. This compares with a total return of the 19.% SPY x-XLF. It is clear that traders believed the Fed would be dovish and the new regime in Washington would be pro-business.
In terms of Fed action or inaction going forward, it is hard to argue either side absolutely. Even the doves argues that a need for “dry powder” exists in case there is another emergency requiring monetary stimulus. The argument makes a good deal of sense as forcing their hand off of the lower bound of already negligible interest rates isn’t exactly tightening. On the other hand, corporations have been taking advantage of the low cost of money and each incremental move could make that large proportion of debt that much more of a burden to service.
Still are we waiting for the decision for the next Chair of the Reserve, but black swans aside, there seems little chance of a severe boat rocking in the curve due to the vanity President Trump feels toward his economy.
Source: FRED St. Louis Fed