How The Flattening Yield Curve Could Lead To A Bear Market For Stocks

04/30/18 02:52PM EDT

The guest commentary below was written by Jesse Felder of  The Felder ReportTo read our short 21-question interview with him click here.

How The Flattening Yield Curve Could Lead To A Bear Market For Stocks - zsa

It seems everyone is talking about the yield curve right now. It also seems most economists and investors are quick to dismiss what would typically signal a clear economic warning as nothing worth worrying about. But from where I sit it looks like this could be a red flag worth paying close attention to.

The reason is that the yield curve, or the spread between the yield on the 10-year treasury and the 2-year treasury, appears to lead corporate spreads by about 30 months. In the chart below you’ll notice the close relationship which suggests rising risk aversion among corporate bond investors lags a flattening of the yield curve fairly consistently.

How The Flattening Yield Curve Could Lead To A Bear Market For Stocks - zed1

This could simply be due to the fact that a flattening curve is typically the product of rising short term interest rates which put pressure on corporate balance sheets. Investors possibly respond to this pressure with a lag only after it becomes readily apparent in their financial statements. It also could simply be the product of rising risk-free rates creating greater competition for risk assets.

Either way, a flattening yield curve, especially when it comes by way of rapidly rising short term interest rates as it does now, creates a one-two punch for risk assets. This should be of concern not only to corporate bond investors but equity investors, as well, as there is a close relationship between risk appetites for both. Widening corporate spreads, especially over the past decade, have regularly been met with falling stock prices.

How The Flattening Yield Curve Could Lead To A Bear Market For Stocks - zed2

Because the degree of the recent flatting in the yield curve is the greatest we have seen since the financial crisis, it is reasonable to assume that over the next 30 months there is a risk for corporate spreads to widen to their greatest degree over that span, as well. If so, it’s hard to imagine it not coinciding with continued turbulence in the stock market if not a full-fledged bear market.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Jesse Felder and reposted from The Felder Report blog. Felder has been managing money for over 20 years. He began his professional career at Bear, Stearns & Co. and later co-founded a multi-billion-dollar hedge fund firm headquartered in Santa Monica, California. Today he lives in Bend, Oregon and publishes The Felder Report. This piece does not necessarily reflect the opinion of Hedgeye.

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