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Stock Investors May Be Watching the Wrong Rate Curve

Treasuries are getting all the attention, but corporate borrowing could be more telling for equities.

Stock Investors May Be Watching the Wrong Rate Curve

Treasuries are getting all the attention, but corporate borrowing could be more telling for equities.

Object may be less relevant than it appears.

Photographer: Bryan Mitchell/Bloomberg
Photographer: Bryan Mitchell/Bloomberg

Stock market investors suddenly seem convinced that rising interest rates could kill the bull market and perhaps the economic expansion. That may turn out to be true. The problem is that they might be watching the wrong rate curve.

Stock market investors appear most focused on the Treasury yield curve. That played a large part in Tuesday’s 799-point drop in the Dow Jones Industrial Average. Longer-term yields, like those on five-year notes or 10-year bonds, tend to be higher than those on two- or three-year notes. The difference between those rates creates the yield curve. Investors need to be compensated for the risk of holding long-term bonds, so those yields are usually higher. The curve is also a traditional indicator of economic expectations. Higher expected future interest rates suggest that investors think there will be higher levels of economic activity. But right now, the opposite is happening. The yields on two- and three-year Treasuries are either about the same or higher than the one on the five-year note. An inverted yield curve is often a sign of an impending downturn.

Dow Dive

Investors seem more worried about the economy than they have been in a while

Source: Bloomberg

But Jim Paulsen, chief stock strategist at the Leuthold Group, says the interest rate gap that investors should be truly worried about is not the one between short- and long-term Treasury yields but the one that marks how much more corporations are paying to borrow. That indicates just how worried investors are that companies won’t be able to pay back their debts, something that would most likely happen with greater frequency during a recession. And that differential has been most correlated to the movement of stocks, Paulsen says. The narrower the gap, the better it is for stocks.

Spread Thin

Companies are paying more to borrow but much less than at other times of stress

Source: Bloomberg

Corporate interest-rate spread is the difference between the average bond yield on 10-year BBB U.S. corporate bonds versus the 10-year Treasury.

The spread between the average rate on 10-year BBB rated corporate bonds and 10-year Treasury bonds is nearly 1.8 percentage points. That’s higher than the 1.7 percentage points the spread has averaged during the past decade, but not by much. And it is far from the highest it has been in other periods of stress. Corporate bonds yielded nearly 2.3 percentage points above government debt in late 2011 and again in early 2016. The spread was nearly double what it is now in mid-2009.

Higher interest rates may ultimately slow the stock market. But the corporate spread isn’t sounding the alarm yet. 

    This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Stephen Gandel at sgandel2@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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