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 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