18Jun

INTEREST RATES AND BOND YIELDS; BOTH IMPACTING MARKETS AND THE ECONOMY

Investors are watching two bellwethers that can impact both the stock market and signal the direction of the economy. The rising yields on government bonds can become an inviting factor for those who want to reduce the risk profile of their portfolios. Also the confluence of yields on short and long duration government bonds can be a sign of a downward turn in the economy.

Likewise, any increases in interest rates by the Federal Reserve can impact the stock market and cause a drag on economic growth. Both have been in flux or have waded into territory that has prompted more attention.

After acclimating to a culture where the federal funds rate was near zero for a long stretch of time, those who benefit by low interest rates have flourished. Since the financial crisis ended, home sales have rebounded and home prices have been back on an upward trajectory. Sales of higher-priced goods have been stronger and borrowing has been more robust. There has only been a hint of inflation.

Circumstances have changed more recently as future inflation fears have been reignited and wages have risen.

The Federal Reserve has to actually throw some water on the fire to keep the economy from overheating. By raising the benchmark rate, the impact reverberates throughout the economy and consumers can feel its pinch in several ways.

Many consumer interest rates are based on the prime rate, which sits just above the federal funds rate. When the Fed raises the federal funds rate, the prime rate increases.

Everything from the delinquency rate on credit cards to mortgages and auto loans to student loans and rental housing rates are impacted by an interest rate increase. This can cause a drag on the economy as consumers have additional out-of-pocket expenses.

The Federal Reserve has indicated that they plan three or four interest rates hikes during the year. Those investors who speculate on such things anticipate the next rate increase as early as the Fed’s June 12-13 Federal Open Market Committee (FOMC) meeting. This would be the second rate hike of the year.

In May, the Fed signaled that they were in no rush to increase the pace of the rate hikes because the modest pace of inflation was within their target range. The Fed had previously raised the benchmark rate in March and then left it unchanged in May at 1.5 to 1.75 percent.
Bond Yields

In the meantime, some Fed members have expressed their concerns about a flattening yield curve; the narrowing gap between the yield on long-term government bonds and shorter-term government debt instruments. A negative or inverted yield curve is an indicator of recession.

The 10-year treasury note recently yielded 2.96 percent while the 30-year treasury bond’s yield stood at 3.12 percent. The 2-year note, which is more sensitive to Fed decisions, recently yielded 2.50 percent. The core inflation number, which the Federal Reserve scrutinizes, was just over 2 percent in April.

The 10-year note’s yield has eclipsed the three percentage point level recently, primarily because of the Fed’s anticipated rate hikes this year. Both bond yields and interest rate levels can be harbingers for the economy. Both are worth watching.


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