The Yield Curve Challenge
Here is a challenge for traders, fund managers and individual investors. We know the level of Fed Funds, and for the moment, let us assume it will be preserved for a time, maybe even going a bit higher since the economic strength continues.
What should be the interest rate for the 10-year note?
If it were to move to 5.65% we would have a positively-sloped yield curve — no inversion. Would that be bullish?
The general theory is that higher long-term rates are bearish for the market. (Yes, I know that financials and hedge funds make money from the "carry trade," benefitting from interest rate arbitrage. That is only a small part of the market.) Most companies benefit from lower rates because they can choose between debt and equity, deciding on the optimal leverage. The ten-year rate is the best indicator of mortgage rates, since it is a good match for duration of mortgages. People can choose to refinance, if they wish to switch from ARM’s to fixed. Most importantly, the long-term rate competes with the earnings yield of stocks. If one can get a guaranteed rate from bonds, why buy stocks?
So let us suppose that you agree with the general theory that a higher bond yield would be a negative. We have an inverted yield curve, with a historically low level of interest rates.
If you cannot specify a bullish scenario from historically low interest rates, you do not have a viable market valuation model. There must be some "yield curve" that works for you.
I submit that anyone who cannot see any bullish scenario with historically modest overall levels of interest rates and growing earnings does not really grasp market history. Since this seems to be the prevailing market consensus, indicated by the declining PE ratios after more than 30 months of profit expansion, it presents an opportunity for individual investors.
For short-term traders the lesson is simple: What change would alter your bearish view? Do you want higher long-term rates?