The Big Picture
“The red coats are coming! The red coats are coming!” – Paul Rivere
Paul Revere was a silversmith and dedicated colonialist who helped coordinate efforts against the British leading up to the American Revolution. Revere was part of a secret group known as “The Mechanics” who are recognized by the CIA as one of the first effective American intelligence groups.
“The yield curve’s inverting! The yield curve’s inverting!”
Nope, this alarm doesn’t have quite the same enticement as the red coats, does it? Although it seems to be nearly as dramatic. Recently, for the first time since 2007 the 2 year treasury yielded more in interest than the 10 year treasury. I trust we all remember what began the year after 2007? Recession! Has the time come to begin discussing an upcoming recession? The subject appears to be gaining headlines. An inverted yield curve can be a fairly ominous indicator of what may come. When the yield curve inverts one message is clear, expectations are changing for the worse, and investors are flocking to safe haven assets.
Have a Plan and a Process!
From the Trenches
“Technically, we did not have a yield curve inversion. An inverted yield curve requires a big spread between the short and long. All we have had is a flat curve.” – Peter Navarro
Well that is one way to spin it I suppose. It was only a little inversion! Those with narratives to push must be talented in their explanations.
To be fair it is true the yield curve only inverted briefly, albeit a couple of times. What is important is the overall shape of the curve is not conveying a lot of optimism about the future! Essentially, while the curve has not fully inverted, it appears heading in that direction.
What does it mean when the yield curve inverts?
- Investors are lowering their expectations on the economy and expecting interest rates to be lowered.
- Investors are buying longer dated U.S. Treasuries which have a higher sensitivity to interest rate cuts. (rates down, price up)
- This action drives longer dated interest rates lower than shorter-term and the yield curve inverts.
A Normal Yield curve: Investors are compensated for buying longer dated securities with a higher yield. This curve also indicates a healthy economy as investors generally expect risk assets to outperform fixed income assets and be compensated for the additional risk.
An Inverted curve: Investors are not concerned about the yield received. They are concerned about the economy and expect interest rates to go down. Capital is shifted to a safe haven asset over a risk asset such as equities. As expectations of an equity decline increase materially.
The common question I receive is why investors would purchase a longer dated fixed income security with a lower yield over a shorter dated with a higher yield?
A changing shape in the yield curve is an indication that the market and economic environment is changing. This should not be ignored! At this point the yield is not the concern. The yield is irrelevant! Longer dated securities are more sensitive to interest rate movements through price change. Investors buy longer dated securities as a price increase becomes the primary objective. Followed by the fact that treasuries are generally negatively correlated to riskier equities. So they may serve as a hedge on a potential equity decline.
Bottom Line: The shape of the yield curve is a key indication on the state of the economy and markets. Regardless of what your favorite talking head’s current agenda may be. Ignore at your own risk!
The Weeds
“The bond market is distorted by what’s happening outside of the U.S.” “That is going to distort our yield curve. And it’s going to weaken the traditional signaling mechanism.” – Mohammed El-Erian of Allianz
Yes! Now we’re spinning. This sounds dangerously like “this time it’s different” doesn’t it? We’ll see…
Now, to be fair again, there is some truth to this statement as well. At least in the sense of interest rate policy. One thing we have had is nearly nonstop stimulus efforts from policy-makers in some part of the world since the financial crisis. So we are not dealing with “normal” circumstances with interest rate policy. That said, the market is still making a very clear statement regarding expectations. Could it be different? Sure, likely not, but possible. Does that even matter? We may be not focusing on the right details here.
Focusing on the right details…
When the yield curve inverts we tend to hear a lot of “don’t worry, the recession won’t begin for 18-24 months, so we have time.” Time for what exactly? I suppose to squeeze a bit more juice from the orange? Ok, we can play that game. I call it musical chairs. Just don’t be the last when the music stops!
To be serious; during the last cycle the curve inverted roughly 16 months before the S&P 500 made all-time highs. The curve inverted in July of 2006 and the S&P 500 made an all-time high in October of 2007. There was another 25% of upside in the S&P 500 (FRED). However, in May of 2000 the curve also inverted. This time the high in the S&P 500 occurred just 3 months later in August of 2000 (FRED). The lag between the two can vary widely! While this data point is important, it is not the only one we need to monitor.
The economy is slowing!
I have been discussing a slowing outlook for some time now. We are seeing slowing in additional data points and some are pointing to recessionary implications. If you have not considered addressing your risk levels, we would recommend sooner than later!
Bottom Line: There are a significant number of pundits that will attempt, at nearly any cost, to spin information. It is important to assess why they are interested in engaging in this rhetoric and what their agenda may be.
*Posts are written covering three primary topics: Macro, or the big picture; Investment Planning considerations; And the Markets – What is going on there?
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