To understand interest rate, rate spread and economic activity is critical for me to understand where the stock market and economy will head to.

Borrowed from Davidson

“Davidson” submits:

There is one group which believes rising rates are bad for economic activity while another group believes they signal economic strength. Both groups miss the key ingredient of the rate impact on economic activity. The key to understanding the interest rate impact on economic activity has 2 parts. The 1st part comes from understanding the rate spread between short-term capital vs. long-term capital. The 2^nd part comes from having a long-term investment focus as opposed to a short-term trading focus. The reason I write about the short-term/long-term so often is because the media’s daily focus is nearly exclusively short-term with one current event (or another) threatening one collapse (or another) when none of these events seem to have any long-term impact whatsoever.

One of the keys to long-term investing on which Wall Street seems to have lost its understanding is the relationship between short-term vs. long-term rates. Even with the many changes which have occurred in banking regulations the past 70yrs, the rate spread between the T-Bill and the 10yr Treasury Note still represents one of the best indicators of future economic activity and the direction of equity prices. The long-term monthly chart presents the relationship to the SP500, the best index for US equities. Regardless of the media focus on one pending collapse or another, the reason why economic activity continues through the many periods of media pessimism typically experienced during a cycle is that the T-Bill/10yr Treasury rate spread remains higher than 0.20% or 20bps(basis points). The T-Bill/10yr Treasury rate spread remains the best proxy for lending profits and lending activity. This holds as true even today as it has been since 1953. It is not whether rates are rising or falling which matters to economic activity. What matters most is this rate spread which determines whether lending activity is likely to be more or less profitable. This spread also provides a measure of investor psychology with the daily chart presenting a dynamic view of current market psychology.

 

History shows that the widest spread occurs during recessions when investors panic which drives T-Bill rates lower. A spread of 2.25%-2.50% appears typical during recessions since 1970. Lending reaccelarates with spreads at these levels once markets have adjusted to the recession. The spread gradually closes as investors gain confidence and shift capital to higher return investments. The spread is a good indicator of lending activity and market psychology. Equity markets and economic activity continue to rise till investor enthusiasm is so strong that it drives T-Bill/10yr Treasury spread below 0.20%. At that point, additional lending slows which in turn slows the existing economic momentum. Shortly afterwards, the excesses which have entered the economy the past several years begin to emerge. Lending institutions pull back further as defaults build. A recession follows and equity markets experience recessionary correction. The rate spread widens and the cycle has come full circle. The actual direction of rates is not the important indicator. It is the lending spread which is a primary economic indicator. With today’s 1.31% (131bps) spread and rising, rising rates today do not have a negative impact on economic activity as many believe. Rising rates today are a signal that investors are selling Fixed Income for higher returns anticipated elsewhere and turning more optimistic.

 

From current T-Bill/10yr Treasury rate spread levels, historicaly it has taken 2yrs-3yrs before the 0.20% level has been reached. I suspect it will take a similar time frame before we see 0.20% again. Till then, it is reasonable to expect we are likely to experience an expanding economy and higher equity prices.

 

Be bullish! The rate spread tells you to be so.

Treasury bills are the shortest-term Treasury issues — they come in three-month and six-month varieties. The fed funds rate, on the other hand, is the rate at which banks lend one another excess reserves — reserves they don’t need to satisfy capital requirements — overnight.Treasury bills are more predictably influenced by the fed funds rate than notes and bonds because Treasury bills and the fed funds rate are competing investments in the money market. The money market is the market for high-quality, short-term debt instruments. Just as individuals put uninvested cash into money market mutual funds, where they can earn interest without putting principal at risk, institutional investors for the same purpose invest directly in the money markets by buying instruments like fed funds and Treasury bills. As investments, fed funds and Treasury bills generally offer comparable yields.

Treasury securities

Investors and those following the movement of interest rates look at the movement of Treasury yields as an indicator of things to come. Their rates are considered an important benchmark: Because Treasury securities are backed by the full faith and credit of the U.S. Treasury, they represent the rate at which investment is considered risk-free.

Click on the links below to find a fuller explanation of the term.