There is no experience more unpleasant for the run-of-the-mill equity investor than a discussion on the term structure of interest rates. It is akin to doing your homework on a beautiful day, but it's the cool kids who speak of disruption and AI and autonomy and ignore relative valuations that always get burned by blowups.
So, it is imperative, if you own any common stocks, that you understand the bond markets, especially the yield curve for U.S. Treasuries. Bond math can be a little scary with talk of convexity, duration yield-to-worst (for corporates) etc., but even if you don't keep a dog-eared copy of Frank Fabozzi's seminal Bond Markets, Analysis, and Strategies handy, as I do, you need to follow bond markets to understand stock markets.
For U.S. Treasuries, Bloomberg's basic page is a very good place to start.
As with equities, it is the movement along the curve and the shifting of the curve that is most important when evaluating bonds. The numerical levels of rates are less important than the level of rates for different time periods compared with each other. At Berkshire's (BRK.A) (BRK.B) annual meeting last week, Warren Buffett stated his belief that "low" rates will continue to produce attractive equity valuations. No one could look at this long-term chart of the yield on the 10-Year U.S. Treasury and disagree with the Oracle's contention that rates are "low" by historical standards. They are, and have been for 10 years.
But what has happened in the term structure of interest rates over the past year is much more telling than 2.43% yield on the 10-year. As the Bloomberg page notes, the yield on the 3-month Treasury has risen by 53 basis points over the past year while the yield on the 10-year Treasury has fallen by 52 basis points. This compression of the yield curve is a classic sign of a late-cycle economy. Resources, both human and material, start to become scarce after years of expansion and inflation forces the cost of money to rise in the short-term. Obviously the Federal Reserve plays a big role in the level of short-term interest rates via its Fed Funds rate target. At the longer-end of the curve the inevitable slowing in the growth rate of the economy allows bond buyers to demand lower interest rates as fears of future inflation are calmed by the implicit forecast of an economic slowdown in the intermediate future.
It may feel as if we are in a period of never ending share price growth, but the U.S. stock market has experienced two massive plunges in the past 20 years. As the S&P 500 recorded record highs in both August 2000 and May 2007, the U.S yield curve was inverted.
Following those peaks, long-term rates fell sharply and the Fed acted to cut rates, providing an artificial steepening of the curve. In 2007, the Fed cut rates by 300 basis points from August (5.25%) until the following March (2.25%,) and kept cutting until, of course, the Fed Funds rate went to zero in December 2008. In May 2000 the Fed inexplicably raised its Fed Funds target to 6.5% and then would end up cutting that rate by 300 basis points by August 21st of 2001.
So, that's the paradigm, The Fed tries to create steepeness in yield curve because that is by definition expansionary. Can they do it again? Can the Fed lower short term rates by 300 basis points when the current Fed funds target is 234-250. Uh, no. Mathematics gets in the way. So, they are stuck.
Could it get worse? Could the 10-year Treasury yield, currently 2.43%, keep dropping? Sure. The yield is just a mathematical product of the bond's price, and that 10-year yield hit a low of 1.50% in June 2016. The current benchmark 10-year is trading at 99.48, but the 2- and 5-year bonds are trading above par, and U.S. investors demonstrated repeatedly in 2014-2016 that they would buy Treasuries at premia to face value in exchange for security of repayment.
So, we're stuck here. The bond market looks terrible, and that is affecting stocks. The headlines may scream of "trade war" but the bond market is telling us there are other factors at work. Lessen your exposure to U.S stocks here. It is a prudent move.