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

Observations and Outlook October 2019

October 8, 2019

Perspective

 Over the past 3, 12 and 18 months there has been a wide dispersion in the returns of various asset classes.  US equites remain range-bound while ex-US, stocks continue to ebb.  Risk-off assets like bonds and gold have done very well over the past year, while stocks vacillate.  Interest rates continue to fall, and inflation expectations are subdued.  Earnings growth for the third quarter are expected to be negative year over year, and likely zero growth for full year 2019. US economic data continues to be weak while Eurozone and Asia may be entering a recession.  Below are the approximate returns over the 3-month, 12-month and 18-month time frames.

 

3 mos.            12 mos.                 18 mos.

S&P500                                          1.7%                 4.25%                      13.5%

Russell 2000 (US small cap)      -2.4%                  -8.9%                         .5%

Euro Stoxx 600                                .8%                    -.5%                      -2.4%

Emerging stocks                            -4.2%                  -2%                       -14%

Gold                                                    4%                 23.1%                     10.4%

Long-bond price (TLT)                 8.1%                 25.2%                     21.8%

Aggregate Bond Index                 2.3%                   7.5%                        9.6%

 

Economic data in the US continues to roll over.  The chart below shows the top three inputs into the LEI (Leading Economic Indicator) as published by the Conference Board.  Data continued to slow and is now in contraction in some areas like manufacturing.  Payroll growth has declined significantly during 2019.  These data points must reverse very soon otherwise we will undercut the 2015 slowdown and increase chances of a recession in the coming months.

econ rolling over 10 2019

 

We’ve been seeing risk-off assets outperform substantially in recent quarters under the pressure of slowing global economic data and lack of growth in earnings.   More recently there are been reports of large-scale rotation from growth stocks (like Consumer Discretionary sector; XLY) to more value-oriented stocks (like Consumer Staples; XLP).  Value has begun to outperform growth.   While not completely uncommon, it is uncommon to see this while Consumer Confidence is very high.  Recently I came across the chart below from Sentimenttrader.com which shows how rare this is.

discretionary vs stpales vs consumer confidence

Discretionary items are what people buy with ‘extra’ money, while Staples are what people need for everyday life.  Defensive areas usually outperform only when consumers and investors are less confidence about the future.  Only just after the market peak in 1969 (far left side) and the 2000 peak (center) confidence was high (survey results) while defensives were beginning to outperform cyclical stocks.  If this rotation continues it may portend tough times for the general stock market.

Why might consumers be confident while investors are buying more defensive stocks over more cyclical stocks is a difficult question.  Sentiment is often a lagging indicator.  People feel good and optimistic after good things happen.  The long string of employment growth and a long bull market has buoyed sentiment, perhaps so much that any contrary information is being discounted.  A poor job report or two may change this outlook.  But again, we are faced with an imminent need for very good economic data points to counteract current downtrends.

Credit Expansion (aka QE/liquidity/debt)

china credit impulse pmi

 

us pmi 10 2019

 

These two charts show how China’s credit impulse (QE/liquidity/Reserve Rate reductions etc.) have a lagged impact on US manufacturing.   Coming out of the 2009 recession, China had the spigot wide open and we can see US PMI hit a high mark in early 2011. The Impulse was removed during 2010 which resulted in a decline in US PMI.  The renewed impulses in mid-2012 and late 2015 helped create the rise in US PMI in 2013 and 2016.  There is about a 6-9 month lag between an expansion in credit and its impact on the real economy.

Today we are seeing the impact of a lack of significant credit expansion which should continue   Global economies appear to be completely reliant upon increasingly larger credit impulses to maintain growth.   China has eased during calendar year 2019, but not as much in the past.  Hopefully we will soon see better US PMI numbers to avoid outright recession in the very near term.

Update on the Yield Curve

fed funds vs 2 year inversion 10 2018

We’re not hearing much on the Yield Curve lately.  It remains inverted with the 10-year Treasury yield being lower than the 90-day T-bill rate.  The 90-day bill and Fed Funds rate (set by the Federal Reserve) follow each other hand in glove.  We can see market rates, the 10-year Treasury yield began to decline in earnest about a year ago.  We can also see how the 90-day rate moved lower prior to the Fed lowering rates.  It is clear that the Fed follows the market.

Current market expectations are that the Fed will lower its rate again in October by another 25 bps (.25%).  I have showed in previous writings how the last two recessions began (the official dating) as the yield curve regained normalcy with the 10-year yield rising above the 90-day/Fed Funds rate by .33%.

If the Fed Funds rate decreases by .25%, from 1.75% to 1.5%, and the 10-year yield remains constant at 1.56%, the yield curve will un-invert and become positive.  Further decreases will cause the spread to go above .33%.   In 2007 the Fed lowered its rate enough (following the 90-day T-Bill) to get below the 10-year yield, resteepening/normalizing the curve again.  This occurred August-October 2007, and the official dating (which was given to us November 28, 2008(!) that it started December 2007.   Waiting for economic data regarding a recession, before reallocating one’s investments will always result in very poor returns

 

Adam Waszkowski, CFA

awaszkowski@namcoa.com

239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

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

Yield Curve Inverts (again, and continuing)

Yesterday, and this morning, the yield on the 30-yr Treasury bond made its all-time historic lows.  This is extraordinary, especially given the vast amount of stimulus and low unemployment rate.

However, the news on the teevee seems to be harping on the Yield Curve Inversion regarding the 10-yr and 2-yr treasury rates.   This is old news.   Yield curve inversions have been everywhere over the past several months, yet barely a mention from the mainstream financial press.  What I was expecting when I turned CNBC on late in the day was the never-before-seen rate on the 30-yr going below the Fed Funds effective rate.   Additionally, the classic ‘inverted yield curve’ is when the 10yr treasury rate goes below the Fed Funds rate (which tracks closely to the 90-day t-bll), which almost occurred January 2019 and again in March.   This inversion first took place May 23rd well into the stock market swoon that began on May 1.

Below is a chart of the Fed Funds rate, 2-,5-,7-, 10-, and 30-yr rates.  In a normal environment the curve steepens from low short-term rates to higher long-term rates.  Inflation expectations and time value of money are what drives this structure.  So, when we see longer term rates move below shorter-term rates it is at a minimum, unusual.  Analysts generally agree that when this normal structure changes, that changes in the economy and markets are afoot.

Yield Curve Inverts - Rates below Fed Funds

As you can see, yields have been falling since late summer 2018.  This coincides with many data points (durable goods, autos, housing starts, etc.) that peaked and began to move down, indicating slower growth (still growing but slower and slower).   It was the last rate hike (light blue line) where the structure began to invert, and March 2019 when rates began to invert strongly.   There was very little reporting about the 2-/5-/7-yr rates going below the Fed rate.   The reason behind the lack of attention is that the stock market was doing well.   If stocks are up, any negative news is spun as “investors brush off X”.   Ignoring information that doesn’t agree with what we see or would like to see is a form of confirmation bias.

In 2007 Bernanke raised rates right through the 10-yr yield to slow down the real estate bubble.  Powell has raised rates and ended QE, making effective rise in the Fed rate much higher and faster than past, going against other central banks, leading to a very strong dollar.   Powell’s statement in July and fair economic data today, make a rate cut in September unlikely, despite market rates screaming to lower.

As I have mentioned before in my Observations, while there will be a recession again in the US, when it occurs is difficult to predict.  The last 3 recession were immediately preceded by a re-steepening of the yield curve.  Stay tuned!

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. 

Fed Does a 180

Prior to December 1, the Fed had widely broadcast that it intended to raise it benchmark rate 3 more times in 2019.   At the December meeting, they lowered that to 2 times in 2019.  In January after the horrid December stock market fall, the Fed changed once again, removing expectations of further rate increases.

The Fed has claimed to be data-dependent and the major economic data points have been indicating slowing growth for most of 2018, and more so since Q2 2018.   The Fed may have realized it overtightened, having raised the Wu-Xia Federal Funds Shadow Rate (Atlanta FRB) by more than 5%.  This was the fastest rate of increase in almost 40 years.

Now the Fed’s balance sheet normalization plan is being questioned and pundits are calling for an early cessation.   In November 2017 the median targeted estimate for the Fed’s balance sheet was just under $3 trillion.   The balance sheet peaked at $4.5 trillion and is currently a tick under $4T.  At the beginning of 2008 it was $800 billion.

So, from a target Fed Funds rate of 3% and Fed balance sheet of $2.75T, to a ‘normalized’ rate of 2.25% and a Fed balance sheet of $4 trillion.    The last few recessions we have seen the Fed raise rates right into economic weakness, only to cease then ease as the recession begins.   With that kind of track record its no wonder people believe the Fed to either be behind the ball, or the outright cause of recessions.

The irony is that the US may have crossed the Rubicon regarding diminishing returns from cheap credit (low rates) aka velocity of money.   While over the past 40 years we have lowered the cost of credit to induce consumption, each recession we must lower the rate below the previous recession lows.  And while we ramp up credit expansion to boost the economy (borrowing more and spending more today) each time, we are getting less and less growth for each dollar borrowed/spent (velocity continues to decrease).  And when there is low velocity, in order to create growth, exponentially larger amounts of money (credit) are required.

I have seen a few reports discussing the idea that low rates decrease future potential growth.  Essentially low rates fail to attract capital, reducing investment, reducing future productivity gains which reduces overall growth.

We have seen the Fed essentially stop tightening (balance sheet runoff should continue to at least this summer) the next step will be for the Fed to ease again, indicating a recession has begun.

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