Why Is No One Looking At The 5-Year, 5-Year??

Less than three weeks into the new year, the S&P 500 is up more than 3%. Rapid gains are either the signal that a reversal is near… or a signal that there is a strong “up” move under way. But the question is — which signal are we looking at right now?

To understand which signal the market is giving us, I want to look at interest rates.

Interest rates tell us about the economic outlook and Federal Reserve policy.

With the interest rate on the 10-year Treasury, we know rates are low. Interest rates include factors for risk, inflation, and a return on investment.

Treasury securities are risk free, so there is no risk factor. The fact that the rate is low confirms that inflation is low. But the outlook for inflation is more important to bondholders than the current rate of inflation.

To measure the outlook for inflation, economists use an idea called forward rates.

(This next part is a little technical, but it’s important to understanding the current stock market, so I’ll explain the idea. You can skip over it if you’d like.)

What Forward Rates Can Tell Us Now

Forward rates are basically the difference in rates on bonds traded in the future. This provides insight into what the market believes inflation will be because the forward rate is based on actual prices rather than guesswork. In effect, the forward rate is the market’s prediction of what the interest rate will be in the future.

A popular measure is the “5-year, 5-year forward rate.” It tells us what traders expect inflation to be 10 years from now.

The mechanics of the 5-year, 5-year rate assumes that you trade zero-coupon bonds. These are bonds that don’t pay interest, so the current price reflects the interest rate. For example, if the current rate is 11% a year, a one-year zero-coupon bond with a face value of $1,000 would be worth about $900. You would pay $900 now to receive $1,000 a year from now.

The 5-year, 5-year rate assumes that you sell a five-year bond now and at the same time buy a 10-year at the same price. There is no cash out of pocket to enter the trade. In five years, you redeem the bond you shorted, and, in 10 years, the bond you bought is redeemed.

Based on the cash flows, this transaction is equivalent to buying a five-year bond five years from now.

And That’s Important Because…

The bottom line of all this math is that the interest rate of the 5-year, 5-year reflects what the market expects a five-year bond to sell at five years from now. The Federal Reserve uses this idea to determine what the market believes inflation will be 10 years from now.

Right now, the 5-year, 5-year is at 1.82%.

Source: Federal Reserve

This is about the same as the yield on the 10-year Treasury. Because interest rates equal the expected rate of inflation plus a real rate of return, the 10-year rate should be above the 5-year, 5-year. This is shown in the next chart where the 10-year rate is shown as the red line.

Source: Federal Reserve

There is an anomaly on the chart, a time when the 5-year, 5-year (blue line) was above the 10-year. The next chart highlights that period and adds a gold line showing how the S&P 500 performed during that time.

Source: Federal Reserve

While interest rates were below inflation expectations, stocks consistently delivered strong gains. The gold line shows the annual change in the S&P 500.

The chart shows that stock returns jumped sharply as rates collapsed in 2012. The second chart shows that we could be at that same juncture now, with the 10-year dipping below the 5-year, 5-year.

This could be the most bullish indicator no one is talking about. It is definitely something I’m watching. It’s entirely possible we could see a sharp rally in the stock market. For now, that appears to be the most likely outcome, but I’ll be watching interest rates and inflation expectations to confirm that.