Monday, July 16, 2018

Beware of the Flattening Yield Curve?

Neel Kashkari, President of the Minneapolis Fed, wrote a new essay on the flattening yield curve:
This time is different. I consider those the four most dangerous words in economics.

Today, policymakers are paying increased attention to the so-called flattening yield curve — the difference in yields between long-term and short-term Treasury bonds. For the past 50 years, an inverted yield curve, where short rates are higher than long rates, has been an excellent predictor of a U.S. recession. In fact, during this half-century period, each time the yield curve has inverted, a recession has followed. Over the past two-and-a-half years, as the Federal Reserve has raised short-term interest rates, the yield curve has flattened dramatically, with the difference between 10-year and two-year Treasuries down from 134 basis points in December 2016 to 25 basis points today, a 10-year low.

Is the flattening yield curve telling us a recession is around the corner?

Some say, “No. This time is different,” and that the flattening yield curve is not a concern. The truth is we don’t know for sure. But we do know the bond market is telling us that inflation expectations appear well-anchored, the economy is not showing signs of overheating and rates are already close to neutral. This suggests that there is little reason to raise rates much further, invert the yield curve, put the brakes on the economy and risk that it does, in fact, trigger a recession.

If inflation expectations or real growth prospects pick up, the Fed can always raise rates then.

The primary reason some policymakers argue that this time is different is because the “term premium” is low today, and so they argue that comparisons to past yield curve inversions are misplaced. If the term premium were at its historical average, these policymakers say, the yield curve would be steeper and an inversion would be further off. This is the same argument some policymakers made in late 2006 to explain why they didn’t worry about the then-inverted yield curve. We now know the Great Recession followed that inversion.

So what is the term premium?

It is the extra returns investors often demand to hold a long-term bond versus a series of short-term bonds. While we’ve given it a technical-sounding name, the truth is we don’t fully understand it. It’s just a residual of the various factors embedded in market prices that we can’t explain.

Why is the term premium low?

Maybe because the Fed’s expanded balance sheet is holding it down. Maybe investors are nervous about trade tensions and are buying Treasuries to hedge those risks. Maybe there is an excess of savings around the world. We don’t know. If I said this time is different because the residual is low, would you be willing to risk a recession on that hunch without clear evidence that inflation expectations are rising above target? I sure wouldn’t.

In the past year, Congress has enacted both a major increase in spending and a large tax cut, and the Federal Reserve has begun winding down its balance sheet. All of these factors increase the supply of Treasury bonds that the private markets must hold. For example, the private sector’s holdings of Treasury securities with remaining maturity of at least 10 years has increased at a rate of $14.2 billion per month so far in 2018 versus a rate of $7.5 billion per month in 2014.

This additional supply should be putting downward pressure on Treasury prices, driving yields up. Yet the 10-year yield has increased remarkably little, to 2.83 percent today. The fact that the 10-year yield is, so far, staying around 3 percent suggests that monetary policy, with a federal funds rate of 1.75 percent to 2.0 percent, is near neutral today. If the markets were expecting higher inflation or stronger real economic growth, that should be showing up as higher long-term bond yields.

If the Fed continues raising rates, we risk not only inverting the yield curve, but also moving to a contractionary policy stance and putting the brakes on the economy, which the markets are indicating is at this point unnecessary.

Deciphering the many signals from financial markets is not an exact science. But declarations that “this time is different” should be a warning that history might be about to repeat itself.
It's Monday, I wasn't in the mood to blog today until I read this gem from Neel Kashkari on my Twitter feed.

Admittedly, Kaskari is an unapologetic dove and he won't be a voting member of the Fed until 2020. By that time, the US recession will be entrenched and if it's really bad, don't be surprised if Trump feels the Bern and loses his bid for reelection.

I'm dead serious, a lot of things can happen over the next two years and if the US economy tanks, it's game over for Trump's reelection bid. He knows it, the Republicans know it and so do the Democrats, many of which are terrified at the prospect of a President Sanders (the US power elite made up of Dems and Republicans are desperately trying to maintain the status quo but Trump and Sanders are trying to shake it up for good).

Anyway, I'm not here to discuss politics, I'm here to focus on the economy and the flattening yield curve.

I began with Kashkari's comment because it's well written, short and to the point. This time isn't different and any pundit, economist or strategist who thinks otherwise is in for a very rude awakening.

On Friday, I explained why it's time to get defensive, noting the following:
The downturn is part of the cumulative effect of Fed rate hikes which is why I keep warning my readers not to ignore the yield curve.

I know, the media will tell you not to fear the flat yield curve and financial websites will tell you the yield curve panic is overdone, but I'm telling you the US and global slowdown is already here and you need to pay very close attention to the yield curve and ignore those who tell you otherwise.

It doesn't mean that markets are going to tank the minute the yield curve inverts, it means risks are rising and allocating risk wisely is going to become harder and harder in an already brutal environment.

And what happened on Monday? Financial shares (XLF) took off as big banks bounced back (click on image):

Let me be very clear here, use any rally in US banks to sell them and go underweight or outright short them.

Look at the daily chart of JP Morgan (JPM) going back one year (click on image)

Some technician is going to tell you it bounced off its 200-day, the MACD is crossing up and it's bullish but the stock is rolling over, incapable of sustaining momentum and making new 52-week highs, so the smart technician is going to tell you what I'm going to tell you: stick a fork in it, it's done.

If you don't believe me, have a look at the 5-year weekly chart of (JPM) which shows you a huge run-up, it’s still bullish as it's above its 50-week moving average but momentum is waning of late and downside risks are mounting as it's as good as it gets for the unstoppable US economy which is unable to generate sustainable wage gains (click on image):

More importantly, a flattening US yield curve doesn't portend well for financials (XLF), undustrials (XLI), energy (XLE) and metal and mining (XME) shares.

These are all cyclical sectors which are leveraged to the US and global economy, so when they roll over, it's typically a bad omen for the economy.

This is why I told you now is a good time to get defensive and focus on more stable sectors like healthcare (XLV), utilities (XLU), consumer staples (XLP), REITs (IYR) and telecoms (IYZ) and hedge that equity risk with good old US long bonds (TLT)

If you don't want to buy sector ETFs, just buy the S&P low volatility index (SPLV) and hedge (up to 50% or more) that equity risk with US long bonds (TLT)

I know I sound ultra bearish and I'm not, but it's worth pointing out we are living the calm before the storm.

What storm? Any storm can come from emerging markets (EEM) to Europe which is still a mess to the US junk bond market (HYG) where some fear a crash is imminent but so far, it's holding on nicely (click on image):

Of course, this can change fast, especially if the yield curve keeps flattening and then inverts which is why I keep warning you not to ignore the yield curve.

Still, others take a more benign view. In his recent blog comment, Is the Yield Curve Bearish for Stocks?, Dr. Ed Yardeni admits the yield curve was a great predictor of recessions in the past but then dismisses it in the current context noting the following:

(5) Bond Vigilantes. In other words, the US bond market has become more globalized, and is no longer driven exclusively by the US business cycle and Fed policies. In my book, I discuss the close correlation between the 10-year Treasury bond yield and the growth rate of nominal GDP, on a year-over-year basis (Fig. 13 and Fig. 14). The former has always traded in the same neighborhood as the latter. I call this relationship the “Bond Vigilantes Model.” The challenge is to explain why the two variables aren’t identical at any point in time or for a period of time. Nominal GDP rose 4.7% during the first quarter of 2018 and is likely to be around 5.0% during the second quarter, on a year-over-year basis. Yet the US bond yield is below 3.00%.

During the 1960s and 1970s, bond investors weren’t very vigilant about inflation and consistently purchased bonds at yields below the nominal GDP growth rate. They suffered significant losses. During the 1980s and 1990s, they turned into inflation-fighting Bond Vigilantes, keeping bond yields above nominal GDP growth. Since the Great Recession of 2008, the Wild Bunch has been held in check by the major central banks, which have had near-zero interest-rate policies and massive quantitative easing programs that have swelled their balance sheets with bonds. Meanwhile, powerful structural forces have kept a lid on inflation—all the more reason for the Bond Vigilantes to have relaxed their guard.

As noted above, a global perspective certainly helps to explain why the US bond yield is well below nominal GDP growth. So this time may be different than in the past for the bond market, which has become more globalized and influenced by the monetary policies not only of the Fed but also of the other major central banks.
This time is different in the sense that global deflation, not inflation, remains the ultimate threat ten years after the great recession and there are structural forces at play which is why the US is trying everything in its power to avoid the global deflation tsunami headed its way.

Why do you think Trump passed huge tax cuts AND is now implementing silly protectionist policies? He wants inflation, he needs inflation.

The problem, of course, is a higher US dollar from protectionist policies will only reinforce deflation once it strikes because it will lower import prices so Trump needs a rethink on his trade policies.

But as far as the flattening yield curve, pay close attention to it, no reason to worry yet even if it inverts but it might a huge warning sign that the US economy is stalling and getting set to roll over.

I've said it before and I will say it again, a slowdown is coming, the Fed needs to heed the warnings of smart economists like Larry Summers and it needs to proceed cautiously here.

Below, Michael Purves of Weeden & Co. says while historically recessions have followed the flattening and inversion of the yield curve, there are stark differences this time around.

Notice how he dismisses the flattening yield curve saying there a 'substantial distortions' influencing the back end of the curve.

I respectfully disagree, there are structural deflationary factors impacting the long end of the curve which Mr. Purves is ignoring or unaware of and as always, the bond market will get the final say.

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