By Richard N. Croft, CEO CIO
Croft Financial Group
Investors are constantly trying to decipher the cause and effect of macro events. Investors must ask whether the production cuts OPEC at their meeting last week will have a meaningful impact on the supply glut that exists in the energy space. Does the modern-day OPEC even matter? How one rates those issues will be reflected in an investment decision to buy or sell energy or transportation stocks.
Early this month we witnessed firsthand the impact macro events can have on the global landscape. A Saturday evening dinner between President Trump and Chinese Premier Xi at the G-20 summit set the stage for an easing of trade tensions between the world’s two largest economies. Global markets reacted positively on Monday but quickly retreated on Tuesday as Trump’s Twitter finger rehashed the “trade deal” as he saw it. Apparently, he was the only visionary to see it!
Certainly “Trump’s Art of the Deal” negotiating strategy was partly to blame for the ensuing 800-point sell-off on the Dow Industrial Average.
But there may have been more to the sell-off than can be explained by Trump’s vitriol.
There has been growing anxiety around points on the US yield curve that have inverted. Some analysts think that may be indicating an economic slowdown which could be exasperated by rising interest rates. In my view the bond market will drive global equity values over the next two quarters and overshadow other macro events related to trade and GDP growth.
What spooked the market is the inversion that occurred at junctures of the US treasury yield curve. Notable at the close of trading on Tuesday, was the inversion between five-year treasury notes (yielding 2.79%) and three-year notes yielding 2.80%. (see figure 1)
Miniscule blips may not seem noteworthy, but traders fear that the three/five inversion may be a precursor of further disruptions along the curve. The worst-case scenario would see an inversion across the entire yield curve (i.e. long-term bonds yielding less than short term notes and treasury bills) which is seen as an early indicator of recession.
Mind you it wasn’t just the three/five inversion that caught the attention of analysts. There was a dramatic – at least for the bond market – slippage in the rate differential between ten-year treasury bonds (yielding 2.91%) and two-year treasury notes at 2.80%. The differential slipped 6 basis points (.06%) in one day, which for bond traders is akin to a 500-point decline in the Dow Jones Industrial Average.
If the yield differential between two and ten year treasuries should flip (i.e. become inverted), that would signal a recession. It could happen! The differential between two- and ten-year treasuries is now 11 basis points (0.11%) which has not been seen since 2007 just before they flipped. We all know what followed!
The two/ten differential is relevant because it has such a major impact on the banking sector. Banks borrow short term (maturities less than two years) and loan long term (maturities ten years and longer). Typically, the largest segment in a US bank’s loan portfolio is 30-year fixed rate mortgages. In that environment, an inverted yield curve has a major impact on margins for US financial institutions.
So, what are we to make of these events? Are they a dire warning of an impending slowdown in growth, perhaps even a recession? Or are these simply dislocations caused by some unusual behavior? One could make a case for either scenario but what’s important is how the US Federal Reserve (FED) reads the tea leaves.
Understanding the Yield Curve
Before getting to the cause and effect of yield curve inversions, we need to understand the minutiae of the yield curve. Effectively the yield curve is a line that plots interest rates at a point in time for bonds having equal credit quality but differing maturity dates.
According to Investopedia, “The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.”
Investopedia goes on to say; “the shape of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped).”
A normal yield curve slopes upward from left to right reflecting higher yields as the term to maturity rises. That’s considered normal because the longer the time to maturity the more potential disruption in the value of the bond. Traders measure the risk associated with time using a concept known as “duration”.
Duration measures how many years it will take for you to be repaid the total cost of the bond through the cash flow from the bond. Say you purchase a bond at $100 and the bond pays you $5.00 per year in interest. It would take twenty years at $5.00 per year to recover the cost of the bond. The bond’s duration would be 20 years.
That’s important because duration leads to another measure referred to as “modified duration” which calculates the present value of the bonds cash flows in years. Without going through the calculation, suffice it to say that the modified duration for our hypothetical 20-year duration bond would be about 12 years… give or take.
Modified duration is used to calculate the bond’s sensitivity to changes in interest rates. Using our modified duration example of 12 years, we would expect the bond to fall 12% for every 1% rise in interest rates and vice versa. It is because of this risk factor that investors typically demand a higher yield for longer duration bonds which is reflected in a normal yield curve.
A flat yield curve, which is the closest observation to the current environment, typically occurs when the economy is transitioning from expansion to slower development and even recession. The yield on shorter term bonds rise as central banks tighten the money supply to tamp down inflation expectations.
Longer term yields tend to contract as portfolio managers shift allocations away from more volatile equities into fixed income assets. That causes bond prices to rise (and longer-term rates to fall) as equity values decline. The potential end game is the inverted yield curve where longer term maturities trade at lower yields than shorter maturities in anticipation of a major economic slowdown and even a recession
Headwinds or Tailwinds
Returning to the main question; what is the yield curve telling us? There is a school of thought that the current dislocations along the yield curve may simply be the result of market forces.
Fact is, we are in a unique situation where the FED is raising rates while reducing their bloated balance sheet from three rounds of quantitative easing after the financial crisis. In other words, the FED is selling massive amounts of bonds in the two to seven-year maturity spectrum which may be the cause of lower values for those maturities. Lower bond prices result in higher yields which may be distorting the curve within that spectrum.
We are also seeing massive bond purchases from the European Union particularly from Germany where short term rates remain in negative territory.(see figure 2).
Depending on what maturity you are looking at, German rates are 225 to 340 basis points (see figure 3) lower than US rates. The point is, European investors can buy lower risk US bonds and receive a higher return for doing so. They also benefit from a stronger US dollar which for the last year, has been rising against most world currencies.
The European Central Bank (ECB) is also planning to exit their quantitative easing at the end of 2018, which presumably, means that the ECB will begin to unwind their balance sheet likely resulting in similar dislocations along the EU yield curve.
If this is the cause of dislocations along the yield curve, then it may not be predicting a recession but simply be the market’s reaction to unusual activity. Even if it is not the case, one can take solace that the yield curve’s notoriety as a leading recession indicator is not grounded in fact. As many analysts contend; the yield curve has correctly predicted twelve of the last five recessions.
So how should investors manage through the current environment? What we know is that the information provided in this article is the same information being used by a data dependent FED to set interest rate policy.
I suspect the flat yield curve is front and center as a risk factor. Raising rates at the short end of the curve while selling bonds in the middle of the curve may spook the market into a recession. A falling stock market impacts wealth and ultimately consumer spending patterns. If consumers tighten their wallets that could trigger a slowdown which could ultimately lead to a recession.
Initially it was thought the FED would raise rates in December and four more times next year. However, the notes from the most recent open market committee meeting were not as hawkish and implied that the FED was not on a pre-destined course for rate hikes.
In my view – and there are many conflicting opinions – there is a 50% chance that the FED raises rates in December and I suspect we will only see two hikes over the next twelve months (including a December hike if it occurs).
In that scenario I suspect global equity markets will continue to wobble which means investors should look to hedge out some of the risk. Covered call strategies that we have talked about in previous editions should provide some protection over the next two quarters.
You might also think about reducing your equity risk by purchasing value stocks with solid dividends. The dividends should provide a floor which should support blue chip well-capitalized companies.