We spend a lot of time on this blog talking about credit and interest rates.

And there’s good reason for that…

No other variable has a greater impact on risk assets (eg stocks and houses).

And this is especially the case given how “financialised” assets are today.

What do I mean by the term “financialised”?

Simple: credit driven.

Credit is the lubricant of today’s economy.

You may not agree with it… as it’s far from what some call “sound money”… but it’s fact.

I will put it simply:

When credit starts to dry up… risk assets fall. 2008 was a good example.

And on the flip side… when credit or liquidity is abundant (like today) risk assets sky-rocket.

However, credit and its supply works through cycles.

There are cycles of credit expansion (as we have experienced post 1980); and periods of credit contraction.

The time to take risk is during expansion… and the time to stay in cash is during contraction.

Simple right!

My belief is we are nearing the end of the greatest credit expansions we have ever experienced.

As I say – this has been raging in earnest for the past 40-years – question is when will it end?

And for that… we watch a few key variables….

Fed: July Statement Key

The next Fed policy meeting is July 25-26.

Put at “x” in your calendar.

Fed Chairwoman Janet Yellen will have an opportunity to elaborate publicly on her outlook when she testifies before Congress next week to deliver the central bank’s semiannual monetary policy report.

You can be sure it will be closely watched….

Irrespective of what Yellen has to say — my approach (as it has always been) is to watch the charts for clues as to when the next (nasty) recession (or credit slowdown) is about to bite (more on that in a minute).

But tonight… I wanted to alert readers what most financial experts are watching — the Fed’s inevitable balance sheet reduction.

This is a big deal…

The US’ central bank has already starting warming the market that it will slowly start to shrink their $4.5T portfolio of bonds and other assets in the next few months.

Regular readers will be familiar with the details…

Now as to when that process will start is anyone’s guess… however it will be between now and the end of the year.

So why does this matter?

Take a look at the relationship between equity prices (ie stocks) and the Fed’s monetary base

Fed Monetary Base versus Stocks

From a trader’s and/or investor’s perspective — we are interested in when the blue-line starts to fall.

Because if it falls sharply… there’s a high probability the red-line won’t be far away.

Time will tell….

From mine, the next announcement from the Fed will include language they are gradually going to phase out the reinvestment of principal of maturing Treasuries and/or mortgage-related assets.

In other words, it will have the net effect is extinguishing money; ie reducing the “blue-line” on the chart above.

The money supply will drop.

However, don’t take that to mean they will be selling assets.

They won’t.

More accurately, they will not be reinvesting. There’s a big difference.

Now the flip-side to this is the (potential) reduced demand for ultra-safe securities (treasurers) as a major buyer is (slowly) withdrawing from the market.

But I am not concerned…

For example, who do think the largest buy of bonds has been the past couple of years in the absence of the Fed?

Do you think it’s China? Nope. Japan? Retirement funds? Hedge Funds?

None of the above.

It’s been commercial banks.

They have stepped up and filled the void of the Fed as they ceased with QE.

This is in turn kept bond prices high… and yields low.

Which is a nice segue to when I think (or know) when things will (eventually) turn ugly. And that’s something called the yield curve.

Yield Curve Holds the Key

A moment ago I said there is one chart (above all others) that holds the key as to when things are about to go pear-shaped (in terms of credit).

And that chart is the yield curve.

Put simply, when the yield curve is steep, banks are making money (which is the case today).

And when they are making money… they are lending… credit flows.

However, when the yield curve flattens (or worse inverts), banks stop making money and guess what… lending seizes.

And what happens to an economy that depends on credit when lending stops?

You got it… it’s not pretty.

The ‘economic growth’ model today is centred around banks lending (and making money).

But let’s wind back for a moment…

The yield curve consists of the interest rates on treasuries plotted against their respective maturities.

Normally, the yields are greater the longer the term (eg 10-Year Treasury) is because it means the investor’s money is tied up for longer.

As maturities lengthen, so do risks, which an investor is compensated for with the higher yield.

A commonly used indicator is the spread between the 10 and 2 year treasury yields — which has been a leading indicator of the last five recessions.

Take a look at the chart below:

10/2-Year Spread

Today the yield on the 10-year sits around 2.37% (peaking around 2.6% last Dec)

A high yield for the 10 year note (eg above 4%) — signifies investors believe that there are more efficient investments out there (eg stocks).

As we explained recently – it is reflective of the inflation and long-term growth expectations.

Now on the other hand, the 2-year yield normally is lower yielding.

However, if the 2 year matches (or worse exceeds the 10-year yield)… that’s when we strap in for the ride ahead.

I have circled these events just prior to the past few recession.

Notice the trend?

In short, banks do not want to see that red line get above the blue line. For that to happen we need to see two things:

(a) the Fed to keep raising its short-term cash rate; whilst
(b) bond prices rallying (ie in turn their yields falling)

Note: when the Fed increases its short-term cash rate – you will generally see the 2 year yield increase.

The 10/2 Spread Today

As I have been saying over the past few years… today there is no cause for alarm with the delta between the 10 and 2-year yield.

The spread is currently around 0.96%

In other words, the 2-year is trading 1.41% and the 10-year 2.37%

And whilst the spread is “flatter” than in previous years – there is very little to worry about as things stand at the time of writing.

Banks are lending and making money (lots of it).

However, we will continue to keep on eye on this for any changes.

We will also continue to listen to Fed language around the direction for short-term rates… their intentions to reduce the money supply… whilst charting the action with the US 10-year and its yield.

Putting it All Together…

When you hear language like “are stocks expensive”… “do I get out now”… “is there a recession coming etc”… ask this question: “what does the yield curve tell us?

In fact, if you have a fund manager (and if they are worth their salt) – ask them.

Half of them won’t have a clue what you are talking about (but they will happily charge you management fees!)

From mine, the (basic) “10/2 spread” has been a great indicator and gives a clear picture of where the economy is and wants to go.

We can garner so much from this very simple (publicly available) chart.

Today the spread is solid.

It’s not as wide as it was but there’s no ground for fear (as many are selling).

Here’s something else before I close…

Many folks love to preach how the market is over-valued.

But their argument is flawed.

Yes, the long-term PE average for stocks is around 15.5x. And today that number is closer to 19x.

But guess what… what are real yields today?

They are next to zero.

Now PE’s of 15.5x have been during times when interest rates were closer to 6-7%.

As such, in a rate environment where they are zero (in real terms)… a PE of 20x is justified.

If anything… we are trading perhaps fractionally above fair value when adjusting for rates.

These are important points and often not explained by financial mainstream.

But for me – it helps to explain why we are where we are… and why there is the potential for this market to go further. And guess what… the tape agrees.

Check back on the weekend when we update the weekly price action (and trends) for both the XJO and S&P 500.

… trade the tape

When investing in shares, you can lose you some or all of your money. The potential gains on my blog are based on investing in Australian and US markets and don’t include taxes, brokerage commissions, or other fees. It’s important you seek independent financial advice regarding your particular situation. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you’ve invested. If in doubt – always seek independent financial advice.

3 thoughts on “All Eyes on the Fed”

    1. QE is targeted at long-term bonds.

      They influence the 2-year (short-term) with the “Fed Funds Rate” (ie official interest rate).

      The only way they can influence the yield on the 10-year is to buy them (ie driving them higher keeping yields (and rates) low).

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