2018 Forecast: Interest Crosses Critical Threshold

Posted On April 25, 2018 2:42 pm

On Tuesday, the yield on the 10-year Treasury finally did something that has long been a part of the 2018 forecast, and that investors were supposedly bracing for. It crossed the 3 percent threshold.

It’s the first time above that level since 2014, and yields continue to tick higher today.

But as I said, given the Fed’s proposed path of three more interest rate hikes this year crossing 3% seemed more a matter of when than if, and yields had already flirted with this level, having traded around 2.95% just two months ago.

So why did stocks suffer a huge down day on Tuesday?  Some site the breaching of 3% as a psychological level that also triggered algorithmic sell programs.

Others focused on more fundamental concerns, such as rotation from stock to bonds or that higher rates might choke off lending and therefore growth which ultimately could lead to a recession.

There are differing expectations about the chances of a recession. Whereas the flattening of the yield curve is worrying for many analysts, others suggest it’s only a temporary situation.

As Jim Bianco and others have discussed, it is not the 10-Year yield rising that is the problem, but the Two-Year Noted and shorter duration paper that has risen to 2%-2.5%. There is a great deal of borrowing priced to Libor, so the rapid increase in rates is projected to have a negative impact on profits.

If the Fed is right and wages are set to rise in response to potential inflation the feedback loop will cause forward earnings to be less than projected. This week we are seeing profit reports exceed already high projections but the stocks are struggling. In my opinion, this suggests that interest rates are going to be an investor concern as the profit story recedes.

Again, global central banks’ QE policies have provided an opportunity for businesses and consumers to gorge themselves on cheap debt. If you don’t believe that credit markets are significantly mispriced, then please explain to me how the Italian government can borrow two-year debt at -31 basis points.

Debt will become a headwind for the equity markets as the year progresses. Even the IMF had to raise concerns about the $164 trillion global debt overhang. Rising interest rates will impact profits. As for when, we don’t know. But the failure of equities to sustain rallies for the last seven days ought to concern investors. Let me add one more caveat about the recent rise in yields and the flattening 2/10 curve in the U.S.

The largest owner of U.S. Treasuries is the Federal Reserve, which still holds more than $3 trillion. The Fed does not hedge its portfolio.  So, where raising rates would historically induce portfolio managers to sell futures or buy puts  to insure against rising rates the Fed does not participate. So for those wondering why the curve is so flat it  is because the Fed is raising short rates but curtailing supply on the long end.

A flattening yield curve has long been associated with foretelling a recession. That said, the popular 2018 forecast remains confident that there’s no immediate danger.

Diana Amoa, fixed income portfolio manager at J.P. Morgan Asset Management, told CNBC’s “Street Signs” that there’s a “very low” probability of a recession this year.

“We think for now it’s technically driven, the yield curve, given just how much central banks have distorted the supply dynamics.”

For now, I’ll agree that the rising rates are a function of positive economic growth and simple normalization of previously extreme monetary policy.  And while there will be hiccups, stocks should be able to hold their ground in coming months.

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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