What Bond Yields Are Telling Investors

Bond yields have tumbled since late October while short-term interest rates barely budged. That tells us a lot about the markets and the economy.

Short-term interest rates went from near zero in 2021 to more than 5.6% in October 2023, their most rapid rise in at least 40 years. Bond rates were slow to follow suit.

It wasn’t until the second half of 2023 that they stayed above 4% for more than a month. The result is an inverted yield curve, with short-term rates higher than intermediate- and long-term rates.

The inversion increased in late 2023 when the 10-year treasury bond yield declined from almost 5% in mid-October to below 4.2% in early December. The short-term yield remained above 5.4%.

An inverted yield curve frequently precedes a recession and always indicates disequilibrium in the markets and economy.

The persistence of high short-term rates indicates there’s underlying strength in the economy. It also could indicate investors expect inflation will remain above the Fed’s 2% target.

Yet, falling intermediate- and long-term rates indicate investors believe the economy is weakening, inflation will dip and short-term rates will be ready to tumble.

As I explained last month, much of the disequilibrium is due to maneuvers by the U.S. Treasury to fund the budget deficits. The government has been issuing more short-term treasury bills and fewer treasury bonds than usual. That reduces pressure on intermediate- and long-term interest rates and increases pressure on short-term rates.

The Fed is unlikely to reduce short-term interest rates by much, as long as inflation is above its target, the employment market is strong and most sectors of the economy appear to grow. Market forces also are unlikely to bring down short-term rates without a drop in economic growth.

That’s why the disequilibrium in interest rates is likely to be remedied by long-term rates rising more than short-term rates decline.

High interest rates make stocks vulnerable. Stocks are less attractive and riskier than alternatives when they’re no longer competing against 0% yields.

Bond valuations declined in the last two years, and cash offers a 5% or higher return with little risk. At the stock market low in October 2022, stock valuations were much higher than at any bear market low.

Valuations since have increased to near record highs, making stock prices heavily dependent on a combination of high earnings growth and low interest rates.

In new bull markets, smaller company stocks usually do well in the first stages, and most stocks participate in the new bull market. The rally since October 2022 is different.

Small company stocks, as represented by the Russell 2000 index, are well below their late-2021 highs and aren’t much higher than their bear market lows. In fact, the Russell 2000 still is below its July 2023 high.

The equal-weighted version of the S&P 500 is doing only slightly better. It is still struggling to return to its July 2023 level and is well below the late2021 peak.

Additional warning flags are underperformance by regional banks and cyclical sectors of the stock market, such as transportation.

While economic growth is lower than a year ago, it still is too high to cause the Federal Reserve to reduce interest rates to the extent the markets expect. Rates are likely to stay high or decline modestly while economic growth slowly declines.