How healthy is the economy, really?

Once the Fed finally starts its taper, this long-standing tool may finally aid investors again. Here's what to look for.

By StreetAuthority Nov 25, 2013 12:49PM

Image: Stock market (© Digital Vision Ltd./SuperStock)By David Sterman                                                                

For many market strategists, the Federal Reserve's multitrillion-dollar stimulus program has had one huge drawback.

The Fed's massive quantitative easing programs have rendered what's known as the yield curve utterly useless -- and that's left everyone in the dark as to just how healthy or weak the U.S. economy remains.

The good news: The Fed's looming retrenchment from stimulus will let the yield curve take its natural shape again, helping investors to better navigate a confounding market environment. (Surging stocks and weak economic data do no typically go hand in hand.) You'll be hearing a lot about the yield curve in 2014, so to better understand its looming implications, let's brush up on the concept now.

What kind of slope?

Bond investors typically demand a higher interest rate for longer-term securities. After all, in an uncertain world, longer time horizons bring a greater chance that something can go wrong. (And if we're talking about bonds, then we're talking about the corrosive effects of inflation or an expectation of much higher bond issuance by Uncle Sam and others.)

So a yield curve is simply the slope of interest rates on short- to mid- to long-term bonds. A healthy yield curve implies an economy poised for growth, and typically looks like this:

Source: Maximum Financial

In recent years, the yield curve has been flatter, as long rates haven't been much higher than short rates. That's because the Fed's QE program has been aimed at pushing rates down, on both the short and long ends. Notably, the Fed aims to hold down short rates (the rate offered on one- or six-month bills) by keeping the federal funds rate near historical lows for the foreseeable future. Unless unemployment falls sharply or inflation rebounds to historically higher levels, look for these short rates to stay down.

Meanwhile, the tapering of the QE will likely enable long rates to rebound. We already saw this phenomenon this past summer when concerns about a Fed taper emerged. As expectations of a Fed tapering diminished in the face of the government shutdown in autumn, rates drifted lower.

But the just-released minutes of the Oct. 29-30 Federal Open Market Committee (FOMC) meeting make it clear that the Fed is aiming to start winding down QE in coming months. The Fed's current view: Upcoming economic "data would prove consistent with the committee's outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months."

And here's where the yield curve comes in. If rates on the 10-Year Treasury punch past the 3% mark and move towards the 3.5% or 4% range, then investors will applaud. The spike won't be due to fears of rising inflation, which is simply not on the horizon. Instead, the move-up in rates will be a reflection of rising global economic activity. Bond markets are still the best mechanism for gauging global economic health. The absence of the Fed's distorting hand allows this mechanism to return.

Outlook 2014

So here's the market's likely biggest concern in 2014: What happens if the Fed retreats and the yield curve doesn't assume its normal shape? If 10-year yields remain at or below 3%, then it's a clear sign that the economy remains in a weak state, which would lead to concern that we'll slip back into recession once the Fed has gone from the scene.

One thing is for sure, we are unlikely to have an inverted yield curve, which means long rates are actually lower than short rates. Inverted yield curves are often a sign of recessionary economic conditions, though with short rates likely to remain below 1% for the foreseeable future, it's hard to see how we'd get an inverted yield curve this time around.

So the only way we'll know the economy is quite weak will be if we have a flattish (but not inverted) yield curve.

When this year began, many assumed that the Fed would already be tapering the QE program. But the Fed eventually realized that the economy remained too weak. Yet as recent FOMC minutes show, the Fed now thinks the economy is starting to perk up a bit.

My take: The Fed needs to back off and let the economy sink or swim on its own because of the moral hazard that QE represents. As I noted recently, I don't think the economy is especially healthy, but I also added that Goldman Sachs' Jan Hatzius predicts much better days ahead. The "fundamental drivers of business investment growth remain strongly supportive. Profit rates are high, lending standards continue to ease, and the starting level of investment remains low. We expect capital spending to strengthen next year, with an added boost if consumption recovers in line with our forecast. This reinforces our view that private sector spending should accelerate in 2014, pushing GDP growth into the 3-3.5% range."

You'll know he's right if the yield curve starts to steepen.

Risks to Consider: The Fed has hinted that it may pursue other steps to bolster the economy, even as QE winds down, and those efforts may also have some distortive effects on the yield curve.

Action to Take: The FOMC meets again on Dec. 17 and 18, and though little action is expected at that meeting, investors should scrutinize the minutes of those meetings when they are released in early January.

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