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Sailor’s Advice

02/27/2021

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Growing up in a beach community, I could predict the weather by remembering:
Red sky in morning, sailor take warning.  Red sky at night, sailor’s delight.”

Growing up in the economics community, I could predict the economy by remembering:
A steepening yield curve is bullish.  A flattening yield curve is bearish.”

The yield curve is the difference between short-term interest rates and long-term interest rates.  Normally, long-term rates are somewhat higher, of course, as the long-term future is more risky to predict than the immediate future.  (Increased risk deserves increased return.)  If business is optimistic and the economy is growing, then the demand for loanable funds in the future will bid-up interest rates in the future.  Hence, long-term interest rates would be higher than short-term interest rates.

However, if business is NOT optimistic and the economy is NOT growing, borrowing would not increase, which reduce the cost of long-term borrowing.  Hence, long-term interest rates would remain flat.   A steep yield curve suggests business is optimistic and the economy will grow.  A flat yield curve suggests business is not optimistic and the economy will stagnant.

In the fourth quarter of 2018, the stock market took an ugly dive into bear territory, because the Fed foolishly raised short-term interest rates.  This caused the difference between short-term and long-term rates to decrease, which caused the yield curve to flatten.  The stock market was fretting about a flat yield curve.

In the first quarter of 2021, the stock market lost 5% in a week, because long-term rates went up.  In other words, the yield curve steepened, and the stock market was fretting about it.  But wait, a steepening yield curve is a good sign, not a bad sign?

Currently, Wall Street is over-reacting to inflation scares, not the yield curve.  After all, the Fed is trying to increase money supply, and Congress will soon approve more stimulus.  Increased money supply and increased demand thru stimulus will surely increase inflation, right?  Not necessarily!

GDP is expected to increase about 6% this year – the highest in decades.  While that is a reflexive bounce from the “flash depression” last year, it is still real growth causing an increase in long-term rates, not inflation.  Wall Street is just doing what Wall Street always does . . . over-reacting!

 

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