Interest Rates and the Yield Curve

TheStreet.com

NEW YORK (TheStreet) -- The Federal Reserve was perceived by markets as dovish when it announced its interest rate policy decision Wednesday. This incited a quick rally and a subsequent fall for a modest gain on the day.

The wild price swings can be attributed to the contradiction inherent in the press release. The current tone remains accomodative, but nothing has happened over the past few weeks to cause analysts to reassess the September meeting as the start date to tighter policy.

The chart below of the U.S. Yield curve is an example of the market's current outlook on monetary policy. The pair below is of iShares Barclays 1-3 Year Treasury Bond over iShares Barclays 20+ Year Treasury Bond .

The yield curve has been gradually steepening as investors continue to view improving economic data as a means to an end for accommodative monetary policy. The trend is still higher, but as more dovish comments have been released by Fed officials, the pair has broken below its multi-month uptrend.

If economic data begin to deteriorate, such as with employment data on Friday, the price action should correct considerably lower.

The next chart is of iShares iBoxx $ High Yield Corporate Bond over iShares Barclays 7-10 Year Treasury . This pair measures the relative strength of junk bonds versus an intermediate U.S. treasury bond.

This pair increases in value when the economic climate is deemed healthy for supporting lower grade companies.

The price action has moved higher as strong economic data have pushed up both rates and riskier assets. The piercing of its trend line in mid-July, however, signals that investor sentiment may be shifting.

Equity indexes look overbought at record highs, and with the Fed's target tightening date for monetary stimulus fast approaching, markets could correct lower in the near term.

The last chart is of SPDR S&P Regional Banking ETF over Guggenheim S&P 500 Equal Weight . This pair measures the relative strength of regional banks over an equal weight equity index.

Regional banks have had an impressive run higher as the yield curve has steepened, allowing profit margins to expand. These banks are better able to borrow at short-term rates and lend at long-term rates, thus capturing the widening spread.

As the yield curve has pulled back and flattened slightly, regional banks have lost the strong bid higher they had a few months ago.

Risks that they may face ahead are a flatter yield curve as well as a declining equity market. If this were to unfold, this pair would lead the market lower.

At the time of publication, Sachais had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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