What normalizing the yield curve means — and why investors should care

The Federal Reserve kicked off its much-anticipated easing campaign this week — its first in four years — which means cheaper rates on most kinds of consumer loans, including auto loans and mortgages. It also means lots of talk from the experts about “normalizing the yield curve” in the bond market — meaning getting back to a setup where bonds with longer maturities yield higher rates than those with shorter-term maturities. The most important thing to understand is that the shape it takes in the coming months and years will have massive implications for both Main Street and Wall Street. The Fed on Wednesday jumpstarted that normalization process when it decided to cut the fed funds rate by a half percentage point, or 50 basis points, to a target range of 4.5% to 4.75%. The fed funds overnight bank lending rate is the rate everybody is referring to when talking about Fed rates. It indirectly influences shorter-duration Treasury yields. “We have, in fact, begun the cutting cycle now,” Fed Chairman Jerome Powell declared Wednesday afternoon at his post-September meeting news conference, shortly after the rate announcement. Wednesday’s Fed rate cut was the first cut since tightening began in March 2022. In fact, it was the first cut since the final Covid-era cut in March 2020, which had brought rates down to a range of 0% to 0.25%. The bond market responded to the Fed rate cut with shorter duration Treasury prices going higher and yields dropping as their inverse relationship dictates. That’s what the Fed wants — to bring down short-end yields so they’re not higher than the longer-end ones. That’s referred to as “yield curve inversion,” which has historically signaled an upcoming recession. The yields on the 2-year Treasury and the 10-year first inverted in the summer of 2022. While they flipped back earlier this month, other shorter-end yields are still higher. The 2-year/10-year relationship is a major way to measure yield curve inversions. The yield curve is what you get when you connect the dots of all the rates across all maturities. The normal shape of the curve more or less goes higher from left to right, indicating bigger yield payouts for investors willing to lend their money to the government for longer periods. Currently, however, the yield curve looks more like a check mark than a gradually rising hill. It’s out of whack, to say the least. That’s because you shouldn’t get paid more to hold a 6-month Treasury , which yields around 4.5%, than say a 10-year Treasury, which only yields about 3.7%. That’s great for investors because they can be paid more in yield on an annualized basis for taking less risk tying up their money for less time. But it is abnormal and when that happens, there are real-world consequences. Consider the consequences on banks, which aim to make money by borrowing from depositors at a lower rate and lending those funds back out at a higher rate. An inverted Treasury yield curve messes with that dynamic. The current high rates on the short end, mean that banks need to offer up higher-yielding alternatives or depositors will take their funds out of liquid savings and checking accounts and purchase short-term Treasurys. If forced to increase the amount they pay depositors, banks have to turn around and increase the amount they’re charging lenders. It would be unsustainable to pay out 4.5% to a depositor and lend out at 4% — the bank would lose money. It also wouldn’t be good risk management to borrow from someone who can come ask for their money back tomorrow and then lend out those funds for a 30-year fixed-rate mortgage without being rewarded for that risk via a robust spread. Why should you care? You aren’t running a bank, right? Let’s use mortgages as an example to illustrate how one aspect of Main Street personal finances is affected. The 30-year fixed-rate mortgage tends to track the 10-year Treasury yield. There is always a spread between the yield on a 10-year Treasury and a 30-year mortgage. Over the past 10 years, that spread has averaged about 1.98 percentage points. In chart below, the green line represents the spread over time. However, it has expanded materially over the past two years because banks have had to charge more for long-term lending because short-term rates are so high. As of the beginning of August, when the 10-year yield was around 3.66%, that spread stood at about 2.63 percentage points — 65 basis points is material when we’re talking about borrowing hundreds of thousands of dollars or more. It makes sense that the spread widens with this unnatural curve. Bank’s can’t focus more on the historical spread than they do their own current cost to borrow. With their own borrowing costs, the rates they pay on deposits, rising, they have no choice but to raise lending rates to whatever level they determine appropriate given the risks. We all know that higher mortgage rates make it more expensive to finance a home purchase. It can seriously impact the monthly payment, which tends to be the primary concern when thinking about shelter costs. We also get a lock-in effect, where folks don’t want to sell their homes and give up the lower rate they were able to get from the bank in years past. Less inventory leads to higher prices, which is why the shelter component for the consumer price index has been so sticky. Lower mortgage rates could help reverse all that — and in the process boost homebuilder stocks and companies such as Club stocks Best Buy and Stanley Black & Decker that rely on demand created by housing formation for their big-ticket items and power tools. It doesn’t just help homebuilders or those companies that benefit from new home formations. Everyone, from private citizens to multinational corporations benefits from a normalized yield curve because normal means less uncertainty, which means more predictability. Money can flow more freely because borrowing and lending rates make economic sense. Normal operating environments also increase confidence in the economy which is crucial for businesses and consumers alike — and of course, the investors investing in those businesses that must always consider the state of the consumer. Confidence in future demand will prompt more investment by businesses. Why will businesses have more confidence in future demand? Well, if you the consumer have more confidence that your job will still be there in six months because the company you work for is on better footing, as all companies are when the economy and financial markets are operating as they should. That provides the sense of security that will allow consumers to spend, or take on loans — and at the end of day, it’s private consumption and the flow of money that keeps the U.S. economy going. If Fed rate cuts can bring short-end bond yields down to more normal rates, then banks wouldn’t have to overcompensate at the long end and longer-term loans like mortgages could come down. That would put more money in the pockets of everyday Americans and help fuel all sectors of the stock market — not to mention the benefit lower rates have on valuations. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust is long.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. 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