The Market: November/December 2017

In the last issue, I wrote about the prospect of interest rates rising and the impact that would have on stock prices

A tame inflation picture

After rising from 2.66% on September 8th to 2.96% on October 26, the 30-year rate on US Treasury bonds has moved back down.

At the close on November 6, the 30-year T-bond had a yield of 2.80%.

The long end of the interest rate curve remains stubbornly contained.  Long-term rates are determined in the market, to a great extent, on the perceived rate of inflation.  Right now inflation remains low.

The Consumer Price Index is running at about 2%. Wages are increasing at about a 2% rate.  The price of gold, after rallying to a high of $1,346 per ounce on September 8 (curious that it peaked with the 30-year yield) has drifted lower to $1,267.

These inflation indicators paint a very tame picture. 

Industrial metals prices and recently oil prices have increased, but so far these commodity prices have not translated into any inflation anxiety. 

My assertion that low rates are a fuel for the FAANG stocks did hold. Amazon’s recent low was on September 26.  This was very close to the recent peak in long term interest rates. As rates eased, Amazon rallied to a new all-time high.  What makes asset prices move is very complicated and comprise of many variables.

It is dangerous to draw conclusions with simple two-factor correlations. Nevertheless, it would seem that keeping an eye on interest rates is a smart thing to do. 

The shape of the interest rate curve

While we are on the subject of interest rates, I’d like to discuss the shape of the interest rate curve.

Most of the time, interest rates are higher the longer the term of a loan, a bond, or a savings account.

Banks, finance companies, certain real estate investments, and other financial enterprises make a profit from borrowing short-term with lower rates and lending or investing longer-term with the corresponding higher rates. This “spread” is greater when the curve is steep and less so when the curve is flatter.

A relatively flat curve is a disincentive for banks to lend and investment vehicles to put money to work.

Currently, the yield curve has been steadily flattening since 2014The spread rallied from August 2016 to the end of 2016 but has fallen steadily since.

The Federal Reserve has been on a path of very short term rate hikes. This is pushing up yields on the short-end but the long-end has refused to move higher and the curve has flattened.

The Federal Reserve has signaled another Fed Funds rate increase in December. It may well be that if the longer-term rates do not rise, the Federal Reserve may not move to raise rates further.

I don’t think the Fed wants a flat or perhaps an inverted yield curve. We’ll see. I think the Fed has to be careful that they do not create the very economic slowdown they are trying to avoid.

Investors need to follow not only the level of interest rates but the shape of the yield curve.

I want to wish everyone a happy, meaningful holiday season. 

— Ian Green, Pendragon Capital Management

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