If you find it amusing to conjure imaginary pictures from lines on pages, I’ll start by suggesting that I think the graph above looks like the rear end of a fish and the one below resembles the crooked smile of the cheshire cat. If numerical trends completely bore you, you can probably stop reading now. But If you want a quick dive into what happened with interest rates over the last three months and why, this is probably worth a minute of your time.
The chart above illustrates three different yield spread curves. In normal market conditions (illustrated in blue), the longer the term of the loan, the higher the interest rate paid by the borrower. Or from an investor’s perspective, the longer duration of the bond, the greater the yield earned. The reason is in the implied risk for keeping someone’s money/letting someone use your money over a progressively longer term. That extra time opens the door for exponentially more variables to ruin even the best-laid plans.
Case in point, I lent money to an acquaintance some time ago. We were in constant communication touching every facet of the business and the loan went swimmingly for the first 2 1/2 years…until suddenly it didn’t. Not only did I cease getting payments, but the capital completely disappeared just before the company filed for bankruptcy. Had my loan been set up to repay after two years instead of three, I would have been much, much happier heading into 2009. I know many people that can tell the same story, which is why it was called the Great Recession, and also illustrates why longer-term loans garner higher rates in a “normal” economy.
In 2022, to attempt to slow down runaway price increases, the Fed raised their overnight rate by 5.25% over a five month time frame. The rest of the bond market didn’t adjust nearly as much, even after two years have elapsed. Consequently, the yield curve in the U.S. has been inverted now for the 27 months.
So fast forward to now. The gold line illustrates the average yield for various maturities leading up to Pioneer Day 2024, where the slope of the line had remained pretty much the same for the entirety of the preceding 24 months. Starting on July 25, word spread that the Federal Open Market Committee was going to cut rates at the September meeting. While their official rate still hadn’t budged at all, the expectation of lower rates in the future began driving down the yield of every single bond duration. We call this “buying the rumor”. Over the next seven weeks markets adjusted to the heightened probability of the Fed finally making good on their word. It was the speculation of a rate cut that dropped longer term loan rates, even before the official rate cut actually happened. The cyan line shows how far interest rates sagged during that time period, up until the day before the FOMC actually took action by lopping 1/2% off their Overnight Rate.
Now look at the red line cataloging the interest rate environment three weeks after the Fed cut rates. The shorter term loans got even cheaper while the longer term debt got more expensive. Not every coupon duration dropped equally. Economic outlooks are shifting. With a few well worded statements and one bold move, the Fed has begun normalizing the yield curve. The anticipated rate cuts of 1/4% coming both in November and December will place the FOMC’s Cost of Funds index in the 4.25%-4.5% range. Take out your level and look what that will do to the graph: it will be nearly flat. Flat curves are highly correlated with their own set of economic setbacks, which will most certainly prod Chair Jerome Powell and his cohort of geniuses to continue slashing into next year as well. The sooner the Fed can get that short end down, the better the longer term economic outlook will be.
