Curvy roads ahead

Stocks had a mixed close on Friday as Fed officials attempted to temper the market’s elated rate cut hopes. Manufacturing PPIs slipped further into the contraction zone while services PPIs moved further into the expansion zone.

Talk is cheap. Ok, so it’s out there. A Fed Pivot, whether real, or an aberration fueled by hopes for great gains in our portfolios, has been officially adopted by the market. The only thing that we can count on with high probability is lots of push and pull between speculation and reality. Until the Fed cuts interest rates, interest rates will remain… um, unchanged. Additionally, the Fed can still raise interest rates, and it has said as much. Most of those pinstripe wearing guys and gals on FOMC have hung up their suits for the year, but the few standouts who probably forgot to check their calendars and have speaking arrangements over the next 2 weeks will have to carry the heavy burden of giving the market a reality check. Something like, “it’s true that inflation is receding, and the economy is buoyant, but that doesn't mean we are going to cut interest rates, because it’s too early to tell if this is permanent.” Got it? Good. I am certainly not going to speculate on exactly when AND IF the Fed will cut interest rates in 2024, but I will commit to saying that more rate hikes like 2022 are in the past.

We have spent a lot of time talking about stocks and how rate cuts would be good for them, but what about bonds? You know the other major asset class. People still buy those, you know. In fact, if you are unsure about what to do with any cash you might just have lying around, bonds might not be a bad alternative to invest in while the great rate debate rages on. If you are a bond buyer, you might start by looking at the Treasury yield curve. I have taken the liberty of plotting the current yield curve along with the yield curve from 3 years ago, so you can see just how much things have changed. Check it out then keep reading.

Let’s start by focusing on the solid blue line which is the current yield curve. You can see that it is still inverted. That is to say that yields of shorter maturities are higher than yields of longer ones. That goes against intuition, as you would expect to be compensated in yield for tying up your money for a longer period of time. Regardless of why these conditions exist at the moment, it would seem wise to take advantage of the higher yields that exist between 6 months and 2 year maturities. Do you know where things are going to be with the economy and the markets in 10 years from now? Will rates be higher or lower? You don’t have to answer that question, but do feel free to flip a coin to fill in the box. Wouldn’t you agree that we have a better understanding of where things will be in the next 5 years? And within 2 years, more confidence yet? Still not convinced? Take a look at the yield curve from 3 years ago - the dotted blue line. As a reminder, 3 years ago was while we were still in the midst of the pandemic. The first thing that should be apparent is that yields were much lower than they are today. If you bought a 2-year note back then, you would have received a yield of 0.13%, and that is not a typo! Today, you would get a yield of 4.41% from a 2-year note, which seems outright juicy relative to back then. Now, let’s agree on another thing. Today’s Treasury yield curve represents an extreme, which exists in the wake of an aggressive Fed tightening to fight extreme inflation. Agree? Let’s also agree that the yield curve that existed in 2020 was also an extreme that existed in the wake of an aggressive Fed easing to keep the economy from imploding as a result of the pandemic lockdowns. Agree?

So, we have 2 extreme yield curves, one resulting from a super-hawkish Fed and one from a super-dovish Fed. Isn’t it reasonable to assume that within the next 2 to 5 years, the yield curve is more likely than not to be somewhere between those 2 curves? If you are shaking your head in a “yes” pattern, stick with me, we are almost there. If you bought a 3-year Treasury note today, you would get around 4.10% yield to maturity. If you held the note to maturity, you would get Par principal back on maturity. However, if within that time the yield does move down, as we speculated a few sentences ago, you would be able to sell those notes for profit prior to maturity, or if you were happy with the yield, just hold on to them until maturity. Your choice.

Now, suppose you are an investor wishing to focus on only income, and you like these current yield levels. If you agree that the curve is likely to slide lower within the next few years, you will want to lock in these yields for as long as practicable (that’s a real word ). You do that by buying bonds with longer maturities. Going back to the top of our conversation and the inverted yield curve. By looking at the chart, you will notice that the 5-year maturity is where things simply bottom out and anything beyond really doesn’t offer you any benefit. In this case you might consider equally splitting your investment between 2-year maturity and 5-year maturity Treasuries. With 2-years yielding 4.41% and 5-years yielding 3.89%, your weighted average yield would be 4.15%. Still above 4%, and you will have locked in half of it for 5 years. Even though you may be focused on income, you will still have the option to sell at a profit if the curve slides downward. But what if the curve slides up? In that case you will simply hold those notes until maturity and invest in the notes with the higher prevailing yields when they mature. Winning and winning. The yield curve is afoot once again, so pay close attention… if you don’t want to miss anything.

WHAT IS AFOOT IN THE PREMARKET

VF Corp (VFC) shares are lower by -6.33% after the company announced that it detected a cyber attack on its IT infrastructure. The company lowered its full-year guidance when it announced earnings in October. Dividend yield: 1.81%. Potential average analyst target upside: +3.9%.

Steel Dynamics Inc (STLD) shares are higher by +4.49% in the premarket after it provided Q4 EPS guidance that exceeded analysts' expectations. In the past 30 days, 4 analysts have raised their price targets while none have lowered targets. The company will announce its current quarter earnings on 1/23. Dividend yield: 1.36%. Potential average analyst target upside: -12.2%.WHY IS THIS NUMBER NEGATIVE? The stock is trading above the median price target set by analysts. Though that can be interpreted as the stock being expensive, it does not mean that the stock cannot trade higher.

FRIDAY’S MARKETS

NEXT UP

• NAHB Housing Market Index (Dec) may have risen to 37 from 34.
• Chicago Fed President Austin Goolsbee will speak this morning.
• The week ahead will feature lots of housing numbers, regional Fed reports, Consumer Confidence, Leading Economic Index, GDP, Personal Income, Personal Spending, PCE Deflator, Durable Goods Orders, and University of Michigan Sentiment. Download the attached weekly economic calendar for exact times and details.