People walk along Wall Street in front of the New York Stock Exchange (NYSE) in New York (Photographer: Michael Nagle/Bloomberg)

Flattening Yield Curve Doesn't Hurt Wall Street's Verve

(Bloomberg Gadfly) -- Usually when the bond market and the stock market disagree, the smart money sides with bonds. This time investors seem eager to take the other side of that trade, but that optimism could soon be misplaced.

The stock market's roaring rebound on Monday showed that investors, despite talk of tariffs, were still backing stocks' sunny view of the economy. The bond market has not presented as cloudless a picture. The spread between the two-year and 10-year Treasury bonds was rising earlier this year. But it has shrunk recently to 0.58 percentage points, back to the narrowest it has been in more than a decade. A flat yield curve tends to forecast weaker economic growth. An inverted one, in which longer-duration bonds yield less than short-term ones, often signals a coming recession.

To be sure, few economists think the U.S. is on the verge of a recession. And I have argued in the past that the yield curve is not as great a predictor of recession as many believe. The Federal Reserve's stimulus policies, which have brought down long-term rates, may be distorting things as well. The yield curve went flat in 1998, more than two years before the next recession. The same thing happened in early 2006. Relatively flat yield curves are not terrible for stock market returns, but flat-line and inverted ones are. Stock market returns have averaged around 6 percent during times when the spread between two-year and 10-year Treasuries has averaged less than 0.5 percentage points, not much flatter than where it is now.

If a flat yield curve can be bad for all stocks, it's particularly bad for banks, which make their money on the spread between paying out short-terms rates to depositors and lending at longer-term rates. When the difference shrinks, so do lending profits. Even there, investors don't seem worried. Bank stocks have been some of the best performers this year. While the S&P 500 Index is down slightly this year, bank stocks are up. JPMorgan Chase & Co., for instance, is up just more than 3 percent. And bank stocks were the second-best performer in Monday's nearly 700-point rally, behind tech stocks. Industrials, which have the most to gain from a retreat in worries about tariffs, were up slightly less than the market in general.

Short-term interest rates are rising, though. So banks could still make more money by holding onto their deposits and passing along less of the increase in yields to their customers. But that means fewer loans, which could hurt the economy. A number of bank analysts have said that lending, while still up in the first quarter, has not risen as much as expected given the strength of the economy. That could indicate a problem on the horizon.

Investors are betting that the yield curve won't be a problem, but if it continues to flatten, the stock market's recent bumpiness will most likely continue.



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