Seems to me that most folks are still waiting to see higher interest rates. But, higher rates are already present in certain parts of the fixed income market. Intermediate and longer maturity bonds are where yields have been going down over the past three years. Meanwhile, shorter term bonds have seen their yields increase dramatically (see chart), and the way this is playing out is unsustainable and alarming.
Most investors understand that longer maturity bonds pay higher interest than their short-term equivalents. As market participants struggle to understand how the Federal Reserve will act in the coming months to more earnestly drive rates higher, the US Treasury bond market has already displayed notable divergence.
Since Summer 2014, very short-term 3-month US Treasury Bills have experienced a 3,270% yield increase (chart). To put this in nominal terms, on September 25, 2015 the 3-month T-bill was yielding an annualized 0.01%. Today (8/29/17), it’s at 1.02%. That’s a very big jump, the bulk of which has occurred since this year’s beginning. The movement is even bigger relative to other maturities.
The 10-Year Treasury Bond was yielding 2.52% on September 25, 2014. Today, it’s 2.139%. Such divergence, or more accurately called “yield curve flattening”, is not a comforting sign. Historically, yield curve flattening is a highly dysfunctional market condition that leads to myopic investment and lending decision-making from not only institutions, such as pension funds and banks, but also income-oriented retail investors. Here’s the basic quandary; why would lenders of capital want to provide funds for longer terms if there’s little extra reward to compensate for the significant increase in timeframe risk? They don’t! Thus, herein lies the fundamental mispricing on risk assets like long-term bonds and stocks.
A flat yield curve is also a harbinger of very bad things to come, as it’s a precursor to the dreaded (but not inevitable) inverted yield curve. Inverted yield curve events have predicted every recessions post-WWII. It’s market environments, like today’s, that I remember the four most dangerous words in the English language, “This time is different.”
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