3/28/19
In case you were reluctant to answer because you don’t remember what an inverted yield curve is (gasp), let us help. An inverted yield curve simply means that short-term treasury bond yields are higher than long-term treasury bond yields. This is the opposite of a normal yield curve, which features short-term yields that are lower than long-term yields.
So what do we call this? “Check-mark” would be a good start, although with yields in the 2-5 year range roughly equal to each other, you could say it’s more of a “Big Dipper” shape. Again, why do we care? Because the shape of the yield curve has an impeccable track record of predicting economic growth over the next couple years. The steeper the curve, the better the outlook for growth. A flatter curve means more modest growth is expected. An inverted curve has almost always correctly predicted a recession.
While “Big Dipper” has an ominous foreboding, we don’t mean to imply that we expect a recession and nasty bear market in the coming months, although the odds of each coming to fruition over the next 2 years has increased. There are some technical reasons why investors have plowed money into the “middle of the curve” (bonds maturing in 2-5 years) which may have pushed those bond yields temporarily. But clearly, the bond market is signaling to the Fed that “not tightening” is no longer good enough; now it is demanding at least one cut to the Fed Funds rate over the next year.
You’ve gotta feel at least a little sorry for Fed Chair Jay Powell. He took a lot of heat in December for suggesting the Fed planned 2 more rate hikes in 2019 and another in 2020, when the bond market was clearly telling him he should be hitting the pause button instead. When he did in fact hit the pause button at the January Fed meeting, the reaction was twofold: that he had wisened up to reality, and that he had kowtowed to the bond market. Then at the March Fed meeting, Powell suggested that the economic outlook had weakened somewhat, so their pause button was locked and loaded. He probably thought he was doing the right thing by validating the bond market. However, that incremental (and subtle) change in tone, coupled with one economic data report last Friday showing the German manufacturing outlook has weakened, sent investors tripping over each other to plow money into bonds, believing that inflation might be dead forever. The rapid influx of money into bonds has caused a number of odd things to occur in the swaps market (don’t ask) and other bond derivative markets, creating the incremental demand for 2-5 year bonds. This isn’t really a flight to safety…the Irish “century bond,” which matures in the year 2116, is one of the best performing bonds this year, up 20% in value. Even bonds from Portugal, Greece, and Spain (fellow PIIGS…remember them?) have seen massive buying. Now 10-year bonds in 4 countries—Switzerland, Germany, Denmark, and Japan—have negative yields, just like they did 3 years ago. For 5-year bonds, you can add Netherlands, Finland, Austria, Sweden, France, Belgium, Ireland, Slovakia, and Bulgaria to the negative yield crowd. Bulgaria?? Makes our 2.2% 5-year yield look pretty high by comparison.
So just as Powell was feeling beaten up by accusations that he is letting the bond market do his job for him, now he is being told to cut rates. You could make a good case that the Fed won’t cut, simply on the grounds that they are concerned about their mandate of operating independently of both the White House and the bond market. But at least he does have some precedent on his side for cutting, if he does at some point (though we know the Fed will be dependent upon economic data between now and then). In 1995 and 1998, after the yield curve nearly inverted each time, the Fed cut rates. In 1995, the Fed had just ended a rate hiking cycle, then 6 months later, turned around and cut rates by 0.75% over the next 9 months. This helped engineer the magical “soft landing” for the late-90’s economy, which managed to grow for 5 more years before the next recession, and the incredible bull market. In 1998, the Fed had been on pause for 1 ½ years, but when it looked like the rest of the world was about to plummet into recession, and the yield curve was about as close to inverting as it is now, the Fed cut rates 3 times for a total of 0.75%. The economy continued to expand without missing a beat, then a year later the Fed started raising rates. They may have overshot, after 1.75% of hikes in 1 year, which led to the 2001 recession.
We know that history doesn’t repeat itself, but it does often rhyme. Is the Fed now obliged to follow the bond market’s lead and cut rates? Of course not. But what if they don’t? Is it possible that a recession hangs in the balance of one decision to lower (or not lower) interest rates by just 0.25%? That’s ludicrous, and the idea that a Fed Funds rate at 2.25%-2.5% is somehow restricting the economy is equally as insane. But the bond market is saying yes, and the bond market is almost never wrong.
It is interesting that the long end of the yield curve is still upwardly-sloping, and long-term rates are still, in fact, higher than short-term rates. We don’t hang our hat on being able to divine the exact shape of the curve, and we’re not fully relying on the esoteric nature of the swaps market as excuses that “this time is different,” the infamous, dangerous saying. We wish that the curve would just normalize. We have implored the Treasury to call off all sales of short t-bills and issue only long bonds in order to counteract all the demand for long bonds. With rates this low, why wouldn’t the government want to lock in? Or perhaps we could end the trade war and free up businesses to make capital decisions that are based on free-market economics rather than the whims of the White House. If we do enter a recession, the blood will be on the President’s hands, whether he admits it or not (that’s a joke; he won’t).
At the end of the day, here’s what we have:
- A semi-dangerous looking yield curve
- An economy that appears to be stable, but whose outlook has been weakening for nearly a half year
- Weakening Chinese and European economies
- A labor market that looked impenetrable, until the weak February jobs report
- Tame inflation
- Stocks that are within 4% of their peak last October
- But are still very cheap compared to bond yields and no inflows into stock funds pumping them up
- Huge amounts of cash sitting on the sidelines in money market funds, private equity funds, and real estate funds
Our “Bull Market Top Checklist” of signposts that would mark the end of the bull market has only 2 out of 10 boxes checked, if one is the semi-inverted yield curve. Of course we are watching all economic indicators like a hawk, and keeping an eye on asset allocations within all our customers’ accounts. While there might be a temptation to trim back exposure to stocks, we always ask ourselves, “what if we’re wrong?” What if the bull market isn’t over? What if this is a soft landing and we’re only in the 7th inning of the expansion? Do we want to risk paper losses in bonds by buying now? Just know that every portfolio that we manage is always prepared to endure an unexpected bear market, which is redundant because every bear market is unexpected.