The Yield Curve Un-Inverting Is Not Your Friend

I have talked about this phenomenon before and must do it again today.  All over the news recently is how the previously inverted yield curve is now no longer inverted.

Yield curve inversion is when short term Federal Funds Rate, set by the Federal Reserve, has a higher yield than longer term rates.   The most common curve-inversion metric is the Fed Funds rate versus the 10-year Treasury bond.  One can also make comparisons between the 30yr, 10yr, 5yr, 2yr and 1yr Treasury yields.  Inversion is regarded as an indicator of a higher risk of recession in the near future.

The chart below shows, in blue, the spread between the US 10 year Treasury yield and the Fed Funds Rate.  The orange is the Fed Funds rate, set by the Federal Reserve.  Red is the 10-year Treasury.

We can see without a doubt that the past 3 recessions (grey bars) were preceded by a decline in the 10-year yield to BELOW the Fed Funds Rate.  Longer term bonds carry higher rates of interest primarily due to inflation expectations.  The natural state is to have the longest-term bonds pay more than shorter term bonds.

When the 10-year is below the Fed Funds rate, the curve is said to be inverted, as its expected longer-term rates are normally higher than short term rates (the Fed Funds rate is an overnight rate).  The curve un-inverts when the 10-year yield goes back above the Fed Funds rate.

The financial media have spilled a lot of digital ink on this topic.  When it first inverted, reports were based on a recession indicator.  Now that it has normalized slightly, I’m seeing reports that the recession risk has passed.

The chart below clearly indicates that the past 3 recessions began as the curve un-inverted. Recessions are the grey vertical bars.

resteepening 11 2019

The process the last 3 times this has occurred was that; 1) market-driven yield on the 10-year bond went down, generally due to deteriorating economic conditions. 2) the 10-year gets below the Fed Funds rate (blue line under the 0% level), inversion. 3) The Fed begins to lower rates to stimulate the economy. It continues to lower rates basically until the recession is over (orange line).  4) The 10-year Treasury bond yield remains flat or vacillates some as the Fed lowers its Fed Funds rate below the Fed Funds rate, un-inverting.

The problem lays in that the Fed is doing the ‘un-inverting’, not market forces.  Had the Fed left rates alone at 2.5% and the 10-year market-driven rate had gone up (due to increasing economic activity)—THAT would be healthy and a good sign for earnings and the economy. 

It is important to remember that stock prices and the economy are only loosely tied together in the short term, stock prices can rise and remain elevated in the early stages of a recession.  Also, it is possible that the curve inversion is falsely predicting a recession, however this indicator has a very high success rate.

Adam Waszkowski, CFA

Happy Fathers Day!

Wishing a Happy Father’s Day to the extraordinary dads who provide support, sacrifice and love every day for their families. 

We’re thankful for these incredible men who truly make a house a home, filling our spaces with fond memories and laughter day in and day out. We celebrate dads everywhere today from all of us at NAMCOA. 

Blame the Fed! (for following through on previously telegraphed guidance)

The Federal Reserve today reiterated it plans to continue what it has been doing and said it would continue to do, much to the chagrin of market participants.

While the last Fed minutes showed more dovishness, actual actions that are indeed ‘dovish’ have yet to occur.  Reducing expected rate increases from 3 to 2 in 2019 was widely interpreted as, ‘the Fed might stop raising rates’, for some reason.  History shows us that the Fed telegraphs well in advance what it intends to do.  Thanks to Alan Greenspan, this has been the case for more than 20 years now.

What has the Fed said it will do in 2019?  Raise rates two more times and continue to drain liquidity from the system via its bond roll-off program.  It is also expected that other nations’ central banks will also cease adding liquidity this year. China may not have gotten the memo though, as they just lower their Reserve Requirement Ratio by 1%, freeing up approximately $100 billion in bank liquidity.  This was announced on Friday, January 4, but was not even mentioned in the Saturday Wall Street Journal!

Here is a picture of global liquidity for 2019.  From adding more than any given year in 2017, to net withdrawal in 2019.   Adjust your expectations accordingly.

qt central bank 10 2018

 

Winter Solstice

They say its always darkest before the dawn, which seems appropriate as we meet the Winter Solstice today, at the lows of 2018.

There is a lot of commentary out there right now about hos investors are ‘worried’ about certain things like Brexit, slowing economies in China and Europe and if that slowing will seep into the U.S.  All these areas of concern have been with us for most of the year.  I have pointed out the Chinese credit impulse (slowing) more than a few times.  Housing and auto sales have been slowing for months.  The only difference is now there is a market decline and all these issues are being discussed.   If the market had not been declining these issues would still be with us, only accompanied by the tag line: “Investors shrug at concerns in Europe”.

In past posts I have described the coming year over year comparisons, 2018 v 2019, regarding earnings and GDP growth.  Every time I have mentioned that 2019 will look much worse than the stellar numbers put up in 2018, thanks largely in part to the one time cut in taxes.   That gave markets a boost and it was hoped that business investment, and wages would go up as a result.  Well it’s the end of 2018 and were still waiting.

The Federal Reserve gave a modest tip of the hat towards global economic concerns by reducing its estimate of rate increases in 2019 from 3 to 2.   There were even rumors that the Fed would skip raising its rate on December 19th and guide to 0 rate increases in 2019.   The Fed NEVER overtly bows to market or political pressures outside of an official recession or panic.   The Fed is in the process (as usual) of raising rates into the beginning of a recession.   Besides the yield curve, there are several other indicators that make recession in 2019 likely.  These indicators have been leaning this way for several months, and finally have tipped far enough that the markets are now concerned and discounting this likelihood.

As this is likely the beginning of a bear market (average -33% post WW2 era), we should expect large rapid moves, both down AND up in the markets.  During the bull market, a 2-4% pullback was common and quickly bought.  Today we see 2-4% intraday moves that continue to fall to hold support.  I expect several more percentage points south before a significant rally in stocks in the first few months of the year.   This will be an opportune time to reassess one’s risk tolerance and goals over the next 1-3 years, as well as make sure that one’s portfolio is properly diversified across asset classes. When stocks go down there are often other asset classes that are performing better, the core idea behind diversification.

It Doesnt Take a Weatherman….

Volatility Continues

2018 is sizing up to be a very volatile year.  Including today, there have been 11 2% down days this year.  There were 0 in 2017, 0 in 2006, and 11 in 2007.

The major indices are currently holding their lows from late October and Thanksgiving week, approximately 2625 on the SP500.  The interim highs were just over 2800, a 6% swing.

The big question of the quarter is if the highs or lows will break first.  Volume today is extremely heavy, so if the markets can close in the top half of todays range, that should bode well for the next few days.

Looking at the big picture, the 200- and 100- day moving averages are flat, the 50 day is sloping downward.  We see the longer term trend is flat while the short term trend is down.  The 50 day and 200 day are at the same level and the 100 day is near 2815.   The averages are clustered together near current prices while the markets intraday are given to large swings in both directions.

Concurrent news topics are the recent good news item of a 90- day trade war truce, and the bad news topics are the problems with Brexit, and the arrest of the vice-chairperson of Huawei, China’s largest cell phone maker.  She is a Party member, daughter of the founder who is also a Party member and has close ties to China’s military.  Maybe not the best person to arrest if one is trying to negotiate a Trade Truce.

My forecast from late 2017 was for large swings in market prices and we have certainly seen this play out.  When compared to past market tops, 2001 and 2007, one can plainly see plus and minus 10% moves as the market tops out then finally breaks down.  Its my opinion that a bear market has likely started, and we have a few opportunities to sell at “high” prices, and get positioned for 2019.

Fundamentally while employment and earnings are good, these are backwards looking indicators.  These are the results of a good economy, not indicators it will persist.  Housing and autos are slowing; defensive stocks are outperforming growth stocks, and forecasts for 2019 earnings range from 0% to 8%, a far cry from 2018’s +20% earnings growth rate.

So, what to do?  Is it more difficult to ‘sell high’ or ‘buy low’?   One is fraught with fears of missing out, the other fears of further declines.   Selling into market strength and perceived ‘resolutions’ to our economic headwinds might be the best bet.  Especially considering the chart below, where in 2019 the global Central Banks will be withdrawing liquidity until further notice, while the Fed insists on raising rates further.

cb balance sheets QT

Happy Thanksgiving !

Please note our office will be closed on Thursday, November 22 and Friday, November 23, 2018 in observance of the Thanksgiving holiday.  Normal operating hours will resume on Monday, November 26, 2018.

Feel free to contact me should you have any questions or if you have specific needs that require special attention.  You can reach me at 239-287-3789 or via email at pmcintyre@namcoa.com.

Have a safe and happy holiday!

 

3rd Quarter Update: Earnings, GDP, U.S. Dollar All Higher

Earnings for companies in the S&P500 grew by more than 20% year over year during the second quarter, repeating first quarter’s Tax Reform-boosted performance.  Companies that beat estimates were rewarded, and companies that missed either on guidance or sales were pushed down, but not to the degree we saw in the first quarter.   The increase in earnings has taken the market (SP 500) trailing P/E ratio down from very expensive 24.3 to modestly expensive  22.6.   Sentiment remains constructive with investors mildly positive, but below average bullishness for stocks’ outlook over the next 6 months.

Economic data is coming in mixed.  While GDP for the second quarter (4.1%) came in at the 5th fastest pace over the past 9 years, a large portion of this can be attributed to increased govt spending and the ‘pull-forward’ effect the Trade War tariffs have had on areas affected by increased taxes.   Adjusting GDP for these areas to average still gives a GDP read in the upper 2% range which indicates growth in the second quarter was strong.    The last previous 4% reads were followed by sequentially lower GDP prints over the following year however.

Real wages have stagnated year over year as inflation has increased its pace.  Wages climbed 2.9% while inflation is running at 2.9% year over year.    Wages had been the feared cause of inflation arising from Tax Reform stimulus.   The 70% climb in oil prices, along with healthcare and housing costs and tariffs/taxes being passed along to consumers are the actual drivers over the past 12 months.

As I referred to in my January Observations and Outlook, the US Dollar was destined to climb in 2018 after an incessant decline throughout 2017 (despite many factors that should have supported the greenback).   In January large traders were certain the US Dollar would continue to fall, and European and Emerging stock markets would do at least as well as US stocks.   Now seven months later, indeed the US Dollar has climbed dramatically while most stock markets outside the US are negative year to date.    The strong dollar has also taken its toll on precious and base metals.  Given the price declines abroad (and attendant airtime and print space) and US Dollar rapid increase, pundits are talking about ‘how bad can it get’, and reasons why the US Dollar will continue to strengthen, it may be time to again take the contrarian side of the dollar argument.

Valuations in emerging markets look much more attractive at lower prices, and no one seems to own gold anymore.  Vanguard recently shuttered one of its metals and mining mutual funds.  The price you pay for an asset has a tremendous impact on the return one sees, and currently prices are low.

Was that the Top or the Bottom?

The Wall Street Journal had a very good article detailing one of the root causes of the February decline.  A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated.  While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets.   Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.

Even with that being known, the impact to market sentiment has been dramatic.  Most sentiment indices went from extremely optimistic to extreme fear in a matter of days.  This change in attitude by market participants may have a lasting impact.  A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market.   Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.

Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up.  This can take several weeks or months.  We can see this in the market tops in 2000 and 2007.  This may be occurring now.  Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’.  This is the level the February decline found support.  This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.

Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index.  Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%.  Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series.   Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices.  But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices.  Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.

“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.