By E.B. Tucker, editor, Strategic Investor
Imagine walking into your bank to buy a Certificate of Deposit (CD). The banker hands you a sheet with the rates: one-month, one-year, two-years, and so on.
You’d expect the interest rate to rise over time. Meaning it would be normal to receive a higher rate for a one-year CD than a one-month CD. But the sheet he hands you looks like this:
Bank CD Rates
1-Month: 2.40%
3-Month: 2.40%
1-Year: 2.13%
2-Year: 1.87%
5-Year: 1.86%
As you study the rate card, something looks different. The bank offers higher interest on a one-month CD than a one-year CD. It offers even less for two years. And much less for five years.
Given the options, you’d probably choose the one-month CD. It pays the most interest. It’s the least restrictive. After a month, you can move the money elsewhere.
That’s not my take.
If I saw these rates, I’d be very worried about what’s ahead. In fact, I’d seek shelter.
The World’s Most Important Indicator
The rates I showed you in the table above are not from a local bank.
They’re from the U.S. Treasury. Those are the rates offered on U.S. government bonds and T-bills as I type. If you think it’s abnormal... you’re right.
It’s something I’ve only seen on the eve of major recessions.
The term for the current condition of U.S. Treasury rates is an inverted yield curve. That means short-term Treasuries offer higher interest than long-term Treasuries.
The U.S. Treasury doesn’t set its own borrowing rates. The free market does that. With just under $16 trillion worth of Treasury bonds, bills, and floating-rate notes held by the public, it’s the largest single market I know of in the world.
Since the buyers and sellers in the world’s largest market set these interest rates, it means they’re also to blame for inverting them.
Remember, the yield on a bond goes down as demand for that bond goes up. In this case, buyers can’t get enough longer-term treasuries. They want nothing to do with short-term treasuries.
Surging demand for two-year, five-year and even 10-year treasury debt sends the yields on those longer-term bonds plummeting.
If you own any assets at all, this is the most important indicator you can watch in the market.
Own Stocks? Watch Bonds
Bonds are boring.
Say you buy a 5% bond. That means a $1,000 investment pays $50 per year until the bond matures.
The only hope for appreciation is that investors become so desperate to own a 5% bond they’ll offer you $1,100 to own yours.
Stocks, on the other hand, give holders the right to company profits. Given the choice between a stock and a bond in a company set to grow like crazy, you’d want to own the stock.
However, if you watch the action in U.S. Treasury bonds, you’ll know where stocks go next.
Today, the bond market indicates the next move for stocks is straight down.
The reason this works so well is a surge in buying sends yields lower. As a reminder, big demand for a bond sends its price higher and yield lower.
In the example I mentioned before, someone might offer you $1,200 for the bond you bought for $1,000. It still pays only $50 in annual interest. That means the new buyer is happy with 4.2% interest ($50 / $1,200).
Just imagine why trillions of dollars would flood into longer-term bonds. Think about why hedge fund managers and the wealthiest investors in the world would pay any price for longer-term safety.
In spite of all that’s wrong with the U.S. government, it does pay its bills. Buying a five-year U.S. Treasury bond today does guarantee you 1.9% interest for the next five years. You’ll also get your principal investment back.
The Big Guys Just Locked in a 1.9% Return
The smartest investors in the world just locked in a 1.9% return for the next five years.
That means they think a guaranteed 1.9% is better than the chance of earning more by owning other assets. For some of them at least, a 1.9% return beats what they expect they could get in the stock market, real estate market, or investments in private deals like the next Uber or Lyft.
If these investors expected stocks to take flight, they’d dump Treasury bonds in favor of stocks.
We’d see Treasury bond prices fall. We’d see yields on Treasuries shoot higher.
That’s not happening today.
If you own stocks, watching the bond market can show you what’s next for your wealth. What it shows today doesn’t look good.
If the inverted yield curve does predict trouble as it did in the past, we’re in for a big change in the markets. It’s not a time to own short-term trades in which you’re hoping for a quick buck.
That quick buck might turn into a big loss.
This would also highlight the value of gold. Gold holds up when other assets don’t. That hasn’t been worth much in the years of recovery since the Great Recession. If the yield curve signal turns out to be real, gold will be in the spotlight overnight.
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