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

Client Note October 2019

November 3, 2019

After a week September, equity markets came back to life in October with the S&P 500 gaining about 2.2%, Euro Stoxx 600 up almost 6% (equal now to April ’19, but still 11% below all-time high from Jan 2018), emerging market stocks gained 4% (remain under April ’19 level, and about 20% below Jan 2018). Aggregate bond index was flat on the month, gold gained 2.5% but remains sideways over the past couple of months.    Portfolios gained across the board, .75% to about 2% on the month.   Our recently added individual stocks continue to do well supporting our core ETF holdings.

Stocks appear to be moving up out of the range we have seen the past several months on the hopes of a trade deal with China and that the current earnings recession is about to end.

Open Interest in gold futures has declined by about 20% as prices have gone sideways and media attention has waned.   At the same time prices have gone sideways and appear to have consolidated enough to provide another base from which to stage another modest rally.

Market driven interest rates have climbed, fallen and climbed again, since August and are consolidating.  With economic numbers (showing the recent past month) have begun to slow their decline (still contracting in durable good, manufacturing) the Fed is indicating less willingness to commit to additional rate cuts.  If data remains ‘less-bad’ I don’t expect a rate cut in December.

Recently we’ve seen very low expectations in employment, earnings and economic data come in ‘less-bad’.  Employment gains were expected at 75k (very weak) to 128k (middling, barely keeping pace with population growth); earnings decline for Q3 year over year at -1% (expected at -3%) and manufacturing PMI slip to 48.3, but greater than expected 47.8 (both indicate contraction).   So, with data not being worse than feared appears to have given market participants confidence that this year may be similar to 2015/2016 and that this bout of weakness will pass.

Western economies grow with credit growth.  In my October Observations, we see how China’s credit impulse impacts US economic data. China’s credit impulse has gone from declining to flat which I believe is the source of our no-longer-falling-but-still-weak economic data.  The Fed restarted a form of QE in September putting in substantial liquidity (comparted to the drain previously) and should give rise to good data in December and January.  If this is temporary remains to be seen.

The US dollar has broken down and may signal an end to its climb (and some decline) which should bode well for commodities which have been added to portfolios.  Oil is on the sidelines still as its in the middle of its 12-, 6-, and 3-month ranges!   We may also see (as mentioned previously) outperformance in ex-US equities (affirmative past 90 days).

 

Adam Waszkowski, CFA

Client Note August 28 2019

August has been a volatile month.  Since August 2, the SP500 has seen 5 moves of 3-4% in both directions for a net, -3%, through today.

Gold, gold miners and long treasuries (TLT) continue to do well putting portfolios into the green for August.  For August, gold +9%; miners +15%, TLT +11%.  Prior to this almost 12 month run in these areas, it was commonly known that ‘gold is languishing”; and “rates will go up”.  Now, its “gold hits 5-year highs”, and “rates seen to continue to fall”.  Often by the time the media reports it widely, the trend is nearing completion.

As we approach Labor Day and the seasonally worst time of the year (Sept/Oct) I am watching for the SP500 to at least stay over 2850, and if we can get over 2940 it opens the door to climb further-but until then markets are under pressure.   Small cap, international stocks are still well below their highs.

Recently it appears the when the US Dollar weakens, US stocks fall while ex-US are more stable.   If the Fed continues to acknowledge further Fed funds rate cuts are likely, this can weigh on the Dollar—unless Europe et al jump ahead and push rates lower via more bond purchases.   So, we may see relative outperformance from ex-US stocks.

Of the individual names purchased recently, one has bee sold out.  IPHI was falling as the sector and general market was climbing, falling below a recent low in July.  The loss was less than 5%.  Cannabis remains under pressure.  Curaleaf reported 200%+ gain in year over year revenue and today saw a drop of 9% at the open, followed by a 23% climb!  This may mark a turn for the sector, but a reversal of these gains will see us abandon this sector in the near term.

The yield curve inversion has been big news.  The 10-yr treasury yield crossed below the 2-yr yield on 8/13 and again on 8/27.  While many other curve inversions have been occurring, this pair, coinciding with a 700 point down day on the Dow has gotten much attention.  The past 3 recessions have occurred as this curve normalizes, that is un-inverts and re-steepens.  I first pointed this out in my quarterly Observation piece January 2019.

 

Adam Waszkowski, CFA

Client Note July 2019

August 1, 2019

 Portfolios saw modest gains in July, approximately 1-1.75%, while the SP500 saw similar gains.  Small cap stocks moved up less than one-half percentage point.   International equities dropped more than 2.5% with emerging markets trailing.

The long Treasury etf (TLT) was down most of the month, until the last day when it managed to finish flat for the month.  Corporate bonds fared slightly worse with high yield underperforming corporates and treasury bonds.  Lower interest rates most directly impact Treasuries as there is no risk of default, whereas on corporates and high yield, a change in the perception of the quality of the debt can push prices despite change in interest rates.

Gold was flat, giving up a percent on July 2, climbing into mid-month then giving it back to end flat for the month.   Gold miners also dropped out of the gate, then climbed almost 11% before dropping yesterday and ending the month up almost 4%.

We are seeing some very constructive moves in the cannabis sector, after significant declines Curaleaf gained 10% in July and Charlottes Web almost 20%.  The etf, MJ was sold out as its heavy weight in Canadian issues continues to wither.

All told, the general equity and bond markets were flat, international did poorly, precious metals were positive and other commodities (base metals, agriculture and oil) fared poorly.

Fed Announcement

Yesterday’s announcement by the Fed to reduce the overnight rate it lends to banks from 2.5% to 2.25% was expected.  Prior to the announcement markets had priced in an 80% likelihood of a .25% cut and only a 20% change of a .5% cut.  Over the past 12 months, growth in auto production, housing, durable goods orders have all been in a gradual decline.  I and others have stated that the Fed had tightened far more quickly than in other periods.  Some combination of slowing growth and recognition that the Fed tightened too much too quickly are what likely brought about today’s action.  June’s economic numbers in some areas have shown an uptick.  It may be a change in trend or just a pause in a continued decline, only time will tell.

Yesterday’s and today’s violent market reactions to ‘not promising more rate reductions’, and a very modest increase in tariffs on Chinese goods bely the fragile psyche of the market.   Very poor economic numbers in the Eurozone and China (which together are about 25% greater than US GDP) are pulling the global economy down and parts of the US economy are beginning to feel it.  After the sugar-high of corporate tax cuts, earnings in 2019 are looking to be about 2% lower than last year.

End-of-trade-war hopes, expectations of better earnings, the gift of cheaper money have been the drivers of stock prices this year.  These ideas are getting denied or delayed and without some re-ignited positive expectations we may see the general stock market vacillate until there is more clarity.   Or, these two days may just be a temper tantrum, showing the markets waning tolerance of slower global trade and dramatic difference between US interest rates and Europe.  And after another day or two we may be off to the races again with the expectation that these issues will be resolved soon.

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. 

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!

 

Why the growth in Cash Balance Plans?

The Pension Protection Act of 2006 (PPA) is long and hard to read, but it played a crucial role in establishing cash balance plans as a viable and legally recognized retirement savings option. Before 2006, cash balance plans faced frequent legal challenges. Those bringing the suits argued that cash balance plans violated established rules for benefit accrual and discriminated against older workers. The rulings on these cases were inconsistent, and many business owners were reluctant to risk establishing a plan that just didn’t have firm legal footing.

The Pension Protection Act ended this uncertainty about the legality of cash balance plans. The legislation set specific requirements for cash balance plans, including:

  • A vesting requirement: Any employee who has worked for their company for at least three years must be 100% vested in their accrued benefits from employer contributions.
  • A change in the calculation of lump sum payments: Participants in a cash balance plan can usually choose to receive a lump sum upon retirement or upon the termination of employment instead of receiving their money as a lifetime annuity. Before 2006, some plans used one interest rate to calculate out the anticipated account balance upon retirement, but, when participants opted to receive an earlier lump sum, the plan called for using a different interest rate to discount the anticipated retirement balance back to the date of the lump sum payment. This could lead to discrepancies between the hypothetical balance of the account (as determined by employer contributions and accumulated interest credits) and the actual lump sum payout, an effect known as “whipsaw”. The PPA eliminated the whipsaw effect by allowing the lump sum payout to simply equal the hypothetical account balance.
  • Clarification on age discrimination claims: A cash balance plan does not violate age discrimination legislation if the account balance of an older employee is compared with that of a similarly situated younger employee (i.e. with the same length of employment, pay, job title, date of hire, and work history), and the older employee’s balance is equal to or greater than the younger employee’s.

There are, of course, many other points included in this lengthy piece of legislation, but the takeaway is this: the Pension Protection Act of 2006 removed the legal uncertainty surrounding cash balance plans and made them a much more appealing option for small business owners.

The number of cash balance plans in America more than tripled after the implementation of the PPA. Additional regulations in 2010 and 2014 made these hybrid plans an even better option, and we anticipate that their popularity will continue to grow. There are thousands of high-earning business owners out there who can reap huge, tax-crushing benefits from implementing cash balance plan – they just have to know about them first.

 

Problem ahead for bond investors?

Bloomberg Barclays US Aggregate has a duration of over 6 (orange line) and a yield of just 2.5% (white line). If we see more corporate refinancing on the longer end (while rates are still low) and at some point a 50 or 100 year US treasury makes its way into the index (https://lnkd.in/gFvUF5g), this could be very problematic. 

 

Add to that a higher duration of Agency MBS if rates increase and prepayments slow (extension risk). 

 

This all looks like a huge amount of interest rate risk for investors with very little upside. The solution: Talk to your Portfolio Manager!