by Mark Bern, CFA
If you watch financial network TV or read what financial
gurus have to say on the Internet you can expect to hear a lot about the yield
curve in the coming months. The fact is
it will have everyone worried about the possibility of another recession. Why?
In every instance when the yield curve inverted in modern history (since
the Great Depression) when the yield curve inverted it was followed by a
recession in the U.S. that began sometime between six and 24 months after the
inversion occurred.
What is the yield curve?
It is the spread (or difference) between the 10-year Treasury note and
the 2-year Treasury note yields (market interest rates). When the 2-year note yield is higher than the
10-year note yield the curve is said to be inverted. The reasoning is simple: investors should
expect to be paid a higher yield for holding a security that has a longer term
to duration because so much can happen over the longer time frame, thereby
increasing the assumed risk.
When the short term rate is below the longer term rate
(inverted) the assumption is that investors believe that there is more risk of
economic slow down over the longer term than in the short term. The bond market is actually more
sophisticated than the equities market and much larger (about twice the size
globally), as well. So, historically the
bond market is far more accurate in predicting the future of economic
strength. It has been infallible, so
far.
The key phrase in that last sentence is “so far.” Why, you may ask? As much as I dislike the term “this time is
different” because it rarely holds true, I must admit that there are
significant differences in the global (and U.S.) economic conditions than we
have ever experienced before. Therefore,
by definition, this time may very well be different.
What is Different Now
Here’s why. There has
never in history been a period of central bank coordination like we experienced
over the last decade. Short-term
interest rates have been held artificially low by many central banks in Europe,
Japan and elsewhere throughout the developed world. The U.S. Federal Reserve policy is running
against the current of other major central banks. I’ll explain a little about why this is in a
moment. But Japan, Sweden and
Switzerland short-term
interest rates are below zero; the ECB rate is zero. Israel’s short-term rate is set at 0.1%,
Denmark and Norway are at 0.5% and Britain is 0.75% while the U.S. is at 2% and
expected to rise by another 0.5% by year end.
On the other end of the spectrum, central banks continue to
buy long-term bonds and other securities with long maturities to hold long-term
rates artificially low, as well. Again,
the Fed is reducing its balance sheet while others continue to increase
holdings. But, is the Fed selling
long-term bonds, short-term bills and notes or is it merely allowing its MBS
(mortgage-backed securities) to mature?
There is a discussion going on within the Fed ranks now about what its
balance sheet asset make up should be (including its size and average maturity)
at the end of the current downsizing exercise.
The Fed’s Balance
Sheet
Since the reductions are relatively small I would venture a
guess that the Fed is reducing assets primarily by allowing them to mature
instead of selling. That would mean that
it is probably continuing to hold its longer maturity treasury notes and bonds
while letting bills and MBS mature. The
reason this is important is that the Fed, by holding on to the long-term bonds,
is depressing long-term rates. It is not
alone in this effort. Remember that
several other central banks continue to buy long-term bonds and notes, also
depressing the respective long-term interest rates. It is a global financial world. When quality of investments are similar but
vary significantly in yield, institutional investors will build positions to
arbitrage the differences, borrowing at low rates to invest in higher
rates.
Carry Trade Currency
and Interest Rate Arbitrage
The current environment is especially profitable since it
can be done at both ends of the maturity spectrum, short and long. It is also beneficial because of currency
trends. With the USD (U.S. dollar)
strengthening against other major currencies lately, big institutional
investors (the only ones who can access the cheapest rates) can borrow for next
to nothing in Japan and Europe and then use those funds to buy short-term U.S.
treasury bills yielding 2% or more while also gaining on the currency
translations.
This situation is very unusual and has not happened before
in history to my understanding. The
other thing that is different is that the economy in the U.S. is still gaining
strength and the global economy is growing as well. Generally, when the yield curve inverts the
U.S. economy is beginning to slow and there are at least signs of potential
recessions elsewhere in the world.
Another difference is that the percentage of bonds issued in
emerging markets that are denominated in USD is far below levels that existed
prior to some (but not all) of the recessions preceded by an inverted yield
curve.
Conclusion
My point to all this is that the yield curve inversion, if
it does in fact occur this time, may not be as predictive as it has been in the
past. With several major central banks
continuing to do all they can to hold down long-term interest rates creating a
huge carry trade by institutional investors playing the arbitrage game. This activity holds longer term rates, even
in the U.S., artificially lower than what those rates would normally be; and
the Fed isn’t helping to offset this because it expects the lower long-term
rates to help bolster the economy while it is raising short-term rates to help
keep inflation at bay. In the end, the
bond market investors are not holding long-term rates low because of an
expected future slow down in economic activity (which is the usual case for an
inverted yield curve) but rather they are doing so because of the relatively
low-risk profits to be gained.
It is a different world and we should not expect the same
outcomes. Having said that, widespread
perception may, in fact, cause a temporary correction in equities simply
because too many fund managers, analysts and investors are bound to prepare for
the inevitable (in their minds) stock market crash and recession. I will not pretend that reality is stronger
than perception. But reality is more
durable. Therefore, if the yield curve
inverts there will probably be a correction in equities but it will probably be
more shallow than expected. As the
economy continues to power ahead investors will wake up and realize that the
correction presents a great buying opportunity.
That is my expectation.
So, have some cash ready to put to work when the next great
opportunity arrives, probably in 2020.
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