fed rate

How Does the Yield Curve Move the Stock Market?

The Fed tightened this week by raising the Fed Funds rate up by a quarter point.

This move surprised absolutely no one. The Stock Market took the increase in stride, and was far more focused on the success likelihood of the tax plan, and on which companies will benefit from these tax changes.

When the Fed tightens, this impacts the short end of what is called the Yield curve. The yield curve examines the yield for each duration of treasury bill, note and bond. For example, on December 14, the 3 month T-Bill yielded the investor 1.32% while the longer durations such as 5 year yielded 2.14% while far out on the curve, the 30 year yields 2.71%.

The Yield Curve Explained

Right now, the yield curve is flattening, which means that the short rates are going up, while the long rates are slowly going down. This is very beneficial for stock prices for two reasons, and if continued could help continue to the rally.

First, investors in search of good investments, will look at treasuries, and will not get too excited. There is not much yield even when you go out 30 years, and most treasuries will likely underperform inflation. In simplistic terms, if investors shun bonds, they need to find a competing investment. That often is stocks. Investors will place  more money into the stock market, and then that increased  demand for stocks helps to push the price of stocks up.

Second, corporations can use the bond market to fund long term investments, and even share buybacks. Taking advantage of the low long term rates is a smart way to finance growth, and corporations have been adding on to their debt loads without increasing their debt service costs.

Is there too much of a good thing? Yes! If the yield curve inverts (short term rates actually go higher than long term rates), that is a sign that the market is likely to have a correction. If companies can borrow at the long end of the curve cheaper than they can at the short end, it often means that a recession and a correction are right around the corner.

So the current conditions are great for stocks, particularly when they are turning in strong earnings growth, but keep an eye on the curve for a warning that the bull run is over.