How a Flatter Yield Curve Could Hurt the Dow

The Dow Jones Industrials (DJINDICES: ^DJI  ) kept flirting with the 17,000 level Monday, dropping 60 points to stay just above the new milestone as of noon EDT. Much of the concern in the market is coming from fears that the Federal Reserve will start raising short-term interest rates in as little as a year from now. For Verizon (NYSE: VZ  ) , American Express (NYSE: AXP  ) , and other Dow stocks that routinely tap short-term credit markets for funding, the potential for yield curve-flattening trends could be a major long-term threat to earnings growth.


Source: U.S. Treasury.

What's at stake with higher rates
The outlook for the U.S. economy has recently become more favorable, and that has many market participants expecting higher yields. The Federal Reserve has traditionally tied low interest rates to the need for economic stimulus, so with employment on the rise and other signs of accelerating growth in key areas of the economy, the central bank could easily start boosting short-term rates while remaining relatively accommodative compared to its longer-term history. This morning, one major Wall Street analyst joined those calling for short-term rate increases sooner than initially expected; given the rise in inflation lately, others believe the Fed might start to raise rates just to be safe about price stability.

Obviously, financial companies are immediately affected by rate changes. American Express benefits from access to cheap short-term capital that it can then lend to cardholders and other borrowers, boosting its net interest margin and supporting earnings growth. AmEx usually pushes rising rates through to consumers, but that doesn't always translate to wider spreads as competitive pressures throughout the industry limit American Express' ability to pass through higher interest costs in their entirety.

Yet the impact on the broader Dow from higher short-term rates could come from the disappearance of an easy performance-boosting trick: issuing short-term debt to raise leverage levels. Dow telecom giant Verizon has benefited greatly from the rock-bottom interest costs available on the bonds it used to finance in part the full takeover of its Verizon Wireless venture. Verizon did a reasonably good job of locking in low rates on longer-term debt, but as the shorter-term bonds mature and require refinancing in the years ahead, it will need either to pay higher interest costs to maintain its debt or to pay off the debt in full to avoid paying more in interest.

As the Dow fights to retain the 17,000 level, investors should also keep an eye on the bond market. With unexpected drops in yield so far in 2014, bond market participants could easily reverse course as the economy picks up steam. That in turn could take away a key driver of profits among Dow components and put further pressure on the stock market in the months to come.

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