Macro
Roger Montgomery

There’s been a lot of talk of inverted yield curves in the US and whether they portend a recession or a stock market crash. But, I wonder whether we need to watch the yield curve as much as exuberance in stocks themselves?

US yield curve inversion

Currently about 3/5ths of the US yield curve, is inverted. To put that in perspective, the last three occasions that occurred – in 1990, 2000 and 2006 – the US went into a recession within a couple of years. Of course, stocks tend to collapse ahead of recessions, so presumably, the fear on investor’s minds is that the market is going to crash some time ahead of any forthcoming recession.

But before jumping at shadows keep in mind the sample above is of only three examples, hardly enough to be statistically significant.

The inversion follows a more dovish stance (meaning a pause on rate hikes) taken by the US Federal Reserve and its falling assessment of the strength of the US economy.

Earlier in the year when US treasury bonds dropped across the board, and US 10-year bonds fell to 2.42 per cent and two years to just above 2.3 per cent, the tech heavy NASDAQ, plunged over two per cent. So, there’s merit even for equity investors in watching developments in the Bond Market.

So, before concluding that the latest bout of inverting is going to lead to recession we need to look at what, if anything, is different this time around.

We must also however be careful not to simply believe ‘this time IS different’, which of course are the four most dangerous words in investing.

Importantly, the three examples listed above, where more than 60 per cent of yield curves were inverted, were all prior to the Global Financial Crisis. Since 2008 the world’s economy and its financial system are vastly different not only from just prior to the GFC but since the end of WWII.

What is the inversion telling us?

It could be that the inverted yield curves are signalling expectations of a sharp decline in inflation. If investors believe goods will be cheaper in the future than they are today, then dollars today are worth less than dollars in the future. In other words, the time value of money turns positive and an inverted curve may not be the harbinger of a recession.

It’s also possible, given how flat the yield curve was prior to the inversion (note in December the difference between the 10-year and two-year bond was just 11 basis points) that even a slight whiff of slowing inflation could trigger an inversion. The important thing here is not the inversion itself, but whether it persists.

It’s interesting at this point to bring in another indicator of a pending recession – unemployment. Since 1965, whenever US unemployment rose more than 50 basis points above its trailing year low, a recession followed. And even though the hit rate is 100 per cent, the sample size is just seven recessions. This is more than the three mentioned earlier but still not enough to be anything more than a coincidence. I do note however there’s a logical relationship – you’d expect rising unemployment to lead to a slowing economy, especially if it’s not accompanied by an offsetting increase in productivity.

Did the Fed make a mistake increasing rates eight times?

Whichever way you look at it, the lower long-term bond yields reflect the fact the market believes the Fed has raised rates too quickly and or too much. In other words, the market currently believes the Fed has made a mistake by hiking rates eight times. And if you add the balance sheet reduction, you could throw in another two or three pseudo rate hikes.

When the first yield curves began inverting late last year the markets seemed to be saying, if not screaming, that the Fed must stop tightening immediately. But now that the Fed has committed to pausing, the failure of the inverted yield curves to normalise suggests the market thinks the Fed went too far. Indeed U.S. bank lending growth appears to be slowing. It’s now only at a third of the high levels it reached prior to the GFC and growth is heavily dependent on debt.

Back in 2016 ten-year bonds yielded 1.36 per cent and the short end of the yield curve – the policy rate – is at 0.5 per cent. Today the policy rate has jumped to 2.5 per cent but the ten-year rate is only slightly higher at 2.38 per cent. There can be no doubt that the Fed is more optimistic about the future than the market.

Without a crystal ball we cannot know whether the Fed has effectively raised rates just enough to slow global growth and normalize rates in time to be able to cut any recession off at the pass – in turn stabilising markets – or whether their actions will cause a violent end to the asset bubbles we see everywhere. What I am reasonably sure about is that the inversion suggests that IF a recession does transpire the Fed will adopt a very different policy response than during past recessions.

But hanging over all of this talk about yield curves is my memory that market yield curves are about 100 per cent wrong when it comes to predicting where rates will be in the future. Plot contemporaneous yield curves against a historical interest rate chart and you’ll conclude likewise.

So, perhaps instead of looking at yield curves we need to remember that with rates so low for so long, the desperate search for yield has, without doubt, resulted in systemic risks associated with a misallocation of resources and mal-investment. You only have to look at the massive multibillion-dollar valuations being ascribed to loss-making companies like Uber, Lyft and Pinterest to be certain of that.

For stock market investors, watching yield curves may not be as important as focusing on valuations. Instead of watching yield curves keep an eye on valuations as your indicator of future returns. When profitless prosperity seems normal you have to remember these companies cannot survive without funds. When they are unlisted they turn to private equity and venture capital for their funding but after they list, they’ll turn to the stock market for additional funding. And stock markets are much less patient than bond markets.



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