Business

Evan Horowitz | Quick Study

Wall Street’s measure of hope and fear is flashing a big warning sign

The New York Stock Exchange.
File 2016/Associated Press
The New York Stock Exchange.

Even as US stock markets hit record highs and investors enjoy the fruits of a long bull run, there’s a less rosy sign coming from Wall Street. Stock indexes may be giving off a go-go green light, but bond markets are actually flashing a yellow warning.

The most worrisome indicator is the flattening yield curve. What’s that, you ask? It’s a measure of hope and fear, a way to gauge what bond investors expect to find in the economic future.

At base, the yield curve is about the relation between interest rates on short-term government bonds and long-term ones. In normal economic times, long-term bonds are expected to pay higher returns, as compensation for the extra risk long-term investors take on. Those risks include the possibility that interest rates will go up, making long-term bonds less valuable, and the risk that investors’ money will be tied up while new opportunities arise.

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But this gap between long and short can vary quite a bit. Sometimes, long-term bonds pay substantially more. Like when the recovery was taking hold in early 2010, and the yield on 10-year Treasury bonds was above 3.5 percent, compared with less than 1 percent for 2-year Treasuries.

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Other times, however, long-term bonds don’t offer such a large premium. And in the most dramatic case, they actually “invert,” meaning that long-term bonds pay lower returns than short-term ones. When that happens, it’s generally a sign of rocky shoals ahead.

As of now, we haven’t hit “inversion,” but that’s the direction the yield curve is headed. Short-term rates have been rising alongside expectations that the Federal Reserve is likely to continue hiking the all-important federal funds rate. But longer-term bonds haven’t kept pace.

Last week, the difference between 10-year and 2-year Treasury bonds hit its lowest level since the financial crisis of 2007, having dropped by half over the last year to about 70 basis points (or 0.7 percentage points.)

So the big question is: How worrying is this trend? Enough to make us rethink the enthusiasm of the stock market?

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That depends on why the yield curve is flattening, and why investors are increasingly willing to stash their money in long-term bonds with relatively low yields.

It may be that long-term rates will eventually catch up with rising short-term rates, after a delay. Especially if the flattening yield curve is being driven by institutional buyers like pension plans and mutual funds — groups whose quest for stable returns requires a commitment to long-term purchases, and who tend to update their portfolios in a more gradual, deliberative way.

Low inflation is another potential explanation. One of the risks long-term investors face is that inflation may rise in the interim, which would eat away at their gains. Currently, however, investors seem pretty confident that inflation isn’t going anywhere, so they’re more willing to accept lower long-term yields.

Both of these possibilities are relatively benign, but there’s another, less sanguine explanation.

It’s possible that the reason investors are willing to accept low, long-term rates is because right now they think the bigger risk is in the short term.

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Think of it this way. When the economy sputters, the Federal Reserve lowers interest rates to compensate — which makes short-term bonds a lot less valuable. So if you think a recession is coming, you’d want to lock in today’s rates for as long as you can. And that may be why investors continue to purchase 10-year or 30-year bonds: they want their money tied up during the tumultuous times ahead.

So what’s a market-watcher to believe? The optimism implied by a rising stock market, or the warning signs in the bond market? As you ponder that unanswerable question, keep in mind that these two markets are actually measuring different things.

Stock prices reflect the future profitability of public companies, not necessarily the health of the overall economy. Bond investors — and particularly those purchasing government bonds — are more directly concerned with issues of macroeconomic and fiscal health, including things like inflation, interest rates, and government debt. Right now, they seem a lot less optimistic about the future.

Evan Horowitz digs through data to find information that illuminates the policy issues facing Massachusetts and the U.S. He can be reached at evan.horowitz@globe.com. Follow him on Twitter @GlobeHorowitz