What is the Smarter Market Telling us?

The inverted yield curve in the bond market has a 100% record of predicting recessions since the late 1960s. A recession affects all asset classes. Therefore, it is essential for all the investors to be aware of the developments in the bond market.

Key observations

  • The bond traders have a very high probability of predicting recessions
  • The yield curve is flattening
  • Do the bond traders sense a trouble
  • Slow economic growth and weak inflation continue to be a worry for the Fed

What are we Focusing on?

We are interested in analyzing the yield curve between the 2-year and the 10-year Treasury. Ideally, the curve should be sloping upwards, because if the short-term yield moves up, the long-term yield should also follow suit. After all, the long-term bond holders should demand a higher yield because, with time, risk and uncertainty increases.

However, at times, the yield curve flattens or even inverts.

When does this happen and why?

The short-term yield is dependent on the federal funds rate, which is set by the US Federal Reserve to fulfill its mandate of maximizing employment, stabilizing prices, and moderating long-term interest rates. However, the long-term rates are set by the bond traders, based on their expectations of inflation, economy and future interest rates.

Therefore, at times, the bond traders are in conflict with the expectations of the Federal Reserve.

So, who should we listen to? The bond traders or the US Federal Reserve.

Bond Traders have been right Every Time in Predicting Recessions

The above chart showcases the difference between the 10-year and the 2-year Treasury yields. One can see that every time the differential has dipped into the negative i.e. when the yield inverts, the economy has fallen into a recession.

The uncanny ability of the bond markets to correctly predict a recession makes it even more important to study the bond market closely.

As seen in the charts, the differential between the 10-year and the 2-year Treasury is in a declining trend and that has got a number of bond traders worried.

Why is the yield curve flattening now?

A yield curve is termed to be flat when the 2-year and the 10-year both have the same rates. Though we are not there yet, the differential has fallen from about 2.66% on 31 December 2013 to 0.98% on July 7.

The yield curve had recovered post President Donald Trump’s election victory, on hopes of a major tax reform and a large fiscal boost. Those steps would have pushed the US GDP and inflation figures higher. However, as the President’s tenure commenced, hopes for a quick reform began to fade and the price differential collapsed. It touched a low of 0.78% just over a fortnight ago. However, since then, there has been a small rebound.

Where is the Curve Now?

The short-term rates are closely linked to the Fed funds rate. As the Fed made its intent clear to bring an end to the ultra-loose monetary policy, the 2-year Treasury rates began to inch higher. It is up from about 0.25% on 12 July 2012 to the current levels of 1.40%.

However, during the same period, the 10-year has traded in a range of about 1.40% to 3.0%. Currently, it is at 2.39%.

Therefore, as you can see, the 2-year has rallied 460% in the past five-year period, whereas, the 10-year has only risen about 71%. This difference in the speed of ascent has led to the curve flattening.

What is the Reason for Flattening of the Curve?

The US Federal Reserve and a number of other central banks across the developed world maintained an ultra-loose monetary policy to support the economy following “The Great Recession”. The Fed reduced interest rates to near zero in December 2008. It then followed it up by a series of quantitative easing measures, where it purchased bonds in the market to improve the liquidity conditions. The easy monetary situation helped boost asset prices across the board.

As the financial condition improved and the economy showed signs of a recovery, the Fed decided to taper its bond purchase before winding it down completely. Nonetheless, the central bank continued to reinvest the proceeds from the bonds that mature.

With the economy on a strong footing and financial risks having reduced, the Fed finally decided to bring an end to its easy monetary policy.

In December 2015, after months of delay, the Fed finally raised rates for the first time since 2006. The second hike, thereafter, had to wait until December 2016.

However, since then, the Fed has increased the pace of its tightening. It has hiked rates twice already in 2017 and is likely to tighten once more by the end of the year. For 2018, it has hinted at three to four rate hikes.

Economic Growth and Inflation Don’t Support Fed’s Bullishness

In its June policy meeting, the US Federal Reserve outlined a plan to shrink its massive $4.5 trillion balance sheet. Though the unwinding is expected to be gradual, it will affect the markets nonetheless. Clubbed with tightening rates this will affect the economy adversely, especially as growth and inflation are not yet showing considerable strength.

The International Monetary Fund (IMF) has recently cut its 2017 and 2018 US GDP forecast to 2.1% from its earlier prediction of 2.3% and 2.5% respectively. The US GDP growth of about 2% is neither great nor a disaster.

On the other hand, the annual US inflation, which had hit a five-year high of 2.7% in February of this year has already slowed down to 1.9% in May.

What are the Economists and Analysts Forecasting?

“We think that inflation expectations will be stubbornly low over the course of the next 18 months. I wouldn’t be surprised to see last week’s sell-off, where interest rates on the 10-year went to [2.3 percent], actually reverse itself,” Washington Crossing Advisors portfolio manager Chad Morganlander told CNBC last week.

On the other hand, Craig Johnson, chief market technician at Piper Jaffray said: “I feel even stronger about our year-end call of 3, 3.25 [percent] in the 10-year bond yield at this point.”

Michael Pento, the president and founder of Pento Portfolio Strategies and author of the book, “The Coming Bond Market Collapse”, and the producer of weekly podcast, “The Mid-week Reality Check”, wrote in his commentary on CNBC that “the yield curve will invert by the end of this year and an equity market plunge and a recession is sure to follow”.

David Rosenberg, an economist in Toronto points that the trusted financial indicator is giving us a warning of the forthcoming trouble. He advises to keep cash in hand and adjust the portfolios. He said: “I can’t tell you when it is going to happen, but the economic cycle has not been abolished, and the chances of a recession are rising.”

On the other hand, Edward Yardeni, of the Yardeni Research is positive on the stock market. He says that the current low bond yields point to a prolonged period of low inflation. However, he cautions that things will change if the Fed delays in raising the short-term rates, as it will lead to irrational exuberance, which will push the stock prices into extremely overvalued territory.

So, what should the Equity Investors do Now?

The analysts and economists are divided in their opinion as these are unprecedented situations. It is, therefore, difficult to correctly forecast what will happen. We are still some distance away from the inverting of the yield curve.

The current valuations of the S&P 500 are stretched, however, there is nothing stopping it from getting overstretched. Therefore, traders should continue to hold their positions with close stop losses. New investments should be done sparingly. It is better to remain in cash to invest at lower levels, which offer a better risk-reward ratio.

Featured image from Shutterstock

Rakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.

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