The Bond Market's Ominous Warning?
The bond market is edging closer to signaling a recession, but don’t panic yet. Stocks could have a lot more room to run even if the feared “yield curve” inverts, history shows.And Fred Imbert of CNBC report, Dow drops more than 450 points, S&P 500 posts worst day since January amid global growth worries:
The spread between the 3-month Treasury bill and the 10-year note went into negative territory on Friday, the first time since 2007. The more widely watched part of the curve — the gap between yields on the 2-year and 10-year debt — is getting closer to inversion as well, falling to just 10 basis points, versus 60 basis points a year ago. The yield curve has been a reliable recession indicator in the past.
This occurred after the Federal Reserve this week downgraded the U.S. economic outlook and signaled no rate hikes this year, worrying bond traders that a possible recession is in the near future.
However, if history is any guide, equity investors shouldn’t worry in the near term. In fact, stocks rose about 15 percent on average in the 18 months following inversions, according to a Credit Suisse analysis last year. The data show the stock market tends to turn sour about 24 months after the yield curve inverts. Three years after an inversion, the S&P 500 is up just 2 percent on average as stocks take a hit on recession fears.
“Yield curve inversion won’t signal doom,” Jonathan Golub, chief U.S. equity strategist at Credit Suisse, said in a note last year. “While an inversion has [preceded] each recession over the past 50 years, the lead time is extremely inconsistent, with a recession following anywhere from 14-34 months after the curve goes upside down.”
The most recent recession, in 2008, came 24 months after the 2-year and 10-year yield curve inverted on Dec. 30 in 2005, Golub pointed out. Back then, the stock market scored an 18.4 percent gain 18 months after the inversion and 17 percent return 24 months later, the analyst said.
Stocks started to go downhill only about 30 months after the inversion in 2005 as the S&P 500 eventually wiped all the gains around mid-2007 and lost a whopping 30 percent in early 2009 as the great financial crisis raged, according to Credit Suisse.
The stock market has jumped 21 percent from its Christmas Eve low as fears of an economic downturn and a full-on trade war with China recede. However, the rally was put on hold this week as the Fed’s policy reversal reignited the recession fears. The central bank announced no rate hikes this year versus the two rate increases that were predicted as recently as December, and it also reduced its outlook for GDP to 2.1 percent in 2019 from a 2.3 percent forecast in December.
“Our core logic behind the inversion call still holds — it’s a bet the market will begin pricing in a ‘policy error’ risk,” said Ian Lyngen, BMO’s head of U.S. rates, in a note. “Unlike when the Fed was still clinging to the hope of another hike or two in 2019, an inversion now will occur as investors worry the FOMC’s on hold stance will prevent them from cutting rates quickly enough to stave off a more severe recession.”
Stocks tumbled on Friday as global growth fears and the Federal Reserve’s more cautious economic forecast sparked investor angst into the weekend.As you can see below, it was a terrible end of week in markets as stocks got slammed particularly hard (click on image):
The Dow Jones Industrial Average sank to its session lows heading into the close and finished down 460.19 points at 25,502.32. Bank stocks led the decline thanks to a sharp pullback in long-term Treasury yields. The S&P 500 fell 1.9 percent to 2,800.71, its biggest one-day drop since Jan. 3. The Nasdaq Composite declined 2.5 percent to 7,642.67 as shares of Facebook, Amazon, Netflix, Alphabet and Apple all closed lower.
“There’s a host of worries out there and those worries continue to mount,” said Peter Cardillo, chief market economist at Spartan Capital Securities. “The fear of recession is increasing.”
“As a result, we have a market that is rethinking some of the optimism that was priced in.”
Sending bank stocks lower was an inversion of the so-called yield curve. The spread between the 3-month Treasury bill yield and the 10-year note rate turned negative for the first time since 2007, thus inverting the curve. An inverted yield curve occurs when short-term rates surpass their longer-term counterparts, putting a damper bank lending profits. An inverted curve is also considered a recession indicator.
Citigroup fell more than 4 percent. Goldman Sachs, Morgan Stanley, J.P. Morgan Chase and Bank of America all declined at least 2.9 percent.
Friday’s moves come after Fed surprised investors by adopting a sharp dovish stance on Wednesday, projecting no further interest rate hikes this year and ending its balance sheet roll-off. Though investors often dislike higher borrowing costs and rate hikes, the motivation for the central bank’s restraint rekindled worries of a GDP growth slowdown. The Fed justified its more temperate outlook by cutting its U.S. economic growth outlook for 2019.
“Maybe one should think about the global economy and not pin everything on the Fed,” Jeffrey Gundlach, CEO of Doubleline Capital, told CNBC’s Scott Wapner. “Except the Fed should operate in consideration of global conditions too.”
Friday saw more weak economic data from around the world that stoked those fears.
IHS Markit said manufacturing activity in Germany dropped to its lowest level in more than six years in March. In France, manufacturing and services slowed down to their lowest levels in three months and two months, respectively. For the euro zone as a whole, manufacturing fell to its lowest level since April 2013. These data sent the German 10-year bund yield briefly into negative territory, its lowest level since 2016.
“The indicators are stacking up to suggest that this is not a 2021 phenomenon, that we could actually see the possibility of a recession starting maybe later this year,” Liz Ann Sonders, chief investment strategist at Charles Schwab, told CNBC’s “Closing Bell. ”
Nike also weighed on the market throughout Friday’s session. The athletic apparel company’s stock fell 6.6 percent on the back of weak quarterly sales growth in North America. Boeing shares dropped 2.8 percent after Indonesian airline Garuda canceled a $6 billion order for 49 Boeing 737 Max jets.
Despite the decline on Friday, stocks were still up sharply for the year. The S&P 500 and Nasdaq are up 11.7 percent and 15.2 percent, respectively. The Dow, meanwhile, has rallied 9.2 percent.
“Let’s not lose sight of the fact that we’ve had a nice rally over the last couple of weeks,” said JJ Kinahan, chief market strategist at TD Ameritrade. “Today is not a great day, but after a strong week or two you tend to get a bit of a sell-off.”
“Now, should you be cautious? Absolutely, because the slowdown worldwide is something people need to be cautious about.”
So what happened? It seems like investors were agitated when the yield curve inverted:
And the gap between 3-month & 10-year Treasury yields inverts for the first time since 2007, despite the dovish tilt by the Fed. pic.twitter.com/Erpf2vvDLt— Lisa Abramowicz (@lisaabramowicz1) March 22, 2019
Yesterday the stock market loved the bond market, today....not so much— GreekFire23 (@GreekFire23) March 22, 2019
Indeed, today everyone was paying attention to the bond market trying ot figure out whether a global recession is around the corner. With US long bond yields sinking lower, investors are getting very nervous, wondering if something nasty lies ahead.
In his comment, The Real End of the Bond Market, Jeffrey Snider paints a dark picure of what lies ahead:
Economists would do well if they would ever learn to curve (stop it with the ridiculous one-year forwards and term premiums nonsense). The bond markets have been saying all along that this was the way it was going to turn out. The reason: liquidity risks. These are high, unusually high because of that one thing. The Federal Reserve has no idea what it takes to fix the broken monetary system (they can’t even get the simplest part right).I will let you read Snider's entire comment here as it is a bit technical in nature and not easy to read (his style is cryptic) but he's basically stating yields are falling because growth expectations are collapsing.
QE’s and bank reserves didn’t accomplish a thing. In light of recent EFF and repo events, officials are turning to more bank reserves. Brilliant.
If you thought that was bad enough, things are still taking a turn for the worse. Having more and more considered a downside scenario and the growing probability for it, attention is now focused on depth and duration.
Typically when yields fall, that's good for stocks because inflation expectations are falling but when they're falling because growth expectations are collapsing, watch out, an earnings recession is coming and "growthy stocks" (ie. Nasdaq shares) bear the brunt of investors' angst.
Moreover, if Jeffrey Snider is right about the monetary system being broken and the Fed and other central bankers being powerless to do anything about it, then that will lead to financial chaos and a severe economic downturn. In this scenario, investors definitely need to hunker down and focus on risk mitigation strategies.
What are risk mitigation strategies? Well, you already know my thoughts on this, allocate more to US long bonds and focus on stable sectors in the stock market.
In fact, have a look at the US long bond price ETF (TLT) breaking out here (click on image):
A little more concerning is the US dollar ETF (UUP) which keeps grinding higher (click on image):
Now, typically when US long bond yields are sinking (prices surging) and the US dollar is making new highs, that's not good, it signals global investors are looking for a flight to safety/ liquidity.
What worries me about the US dollar grinding higher is a lot of emerging market debt is dollar-denominated and if this trend continues, it could bring about an emerging markets debt crisis.
Right now, there's no imminent threat as emerging markets bonds (EMB) and stocks (EEM) are in good shape despite today's selloff (click on images):
But if global growth concerns persist, these are the charts you need to be paying attention to.
Earlier today, IHS Markit released its preliminary results for the March US manufacturing purchasing managers’ index, with the reading falling to a 21-month low of 52.5. This was below expectations for 53.5, and February’s reading of 53. Service-sector PMI slipped to 54.8 from 56, and came in below expectations of 55.5. Each reading, however, held above the key level of 50, indicating expansion.
“A gap has opened up between the manufacturing and service sectors ... with goods-producers and exporters struggling amid a deteriorating external environment and concerns regarding the impact of trade wars,” Chris Williamson, chief business economist at IHS Markit, said in the statement Friday. “The survey is consistent with the official measure of manufacturing production falling at an increased rate in March and hence acting as a drag on the economy in the first quarter.”
If you read the statement, I found this somewhat concerning:
Private sector companies responded to slower new business growth by reining in staff hiring during March. Latest data pointed to the weakest increase in payroll numbers since June 2017.We will have to wait till the first Friday of April to find out if US payrolls took another hit in March but this certainly wasn't encouraging.
What does all this mean for US stocks? Well have a look at the one-year daily and 5-year weekly charts of the S&P 500 ETF (SPY) which remain in an uptrend despite the pullback (click on images):
This is hardly something to panic about but it can be that stocks are rolling over here and taking a breather, or it could be something far worse.
Yesterday, Zero Hedge posted a decent comment, Battle Of The Quants: Kolanovic Counters McElligott With 6 Reasons Why It's Time To Buy.
I won't bore you with the details but here are the six factors Nomura's strategist Charlie McElligott cited to warn the bank's clients that the market's "pullback window" has opened:
- The market's traditional slide after a major capitulationary inflow
- Fading dealer delta-hedging demand
- The continued rise in CTA "sell triggers", which will launch a renewed systematic bout of selling once the threshold level goes in the money
- The ongoing QT and the heavy month-end Fed balance sheet runoff
- Stock-selling from quarter-end pension rebalancing
- The buyback blackout period window begins
People glorify the world's richest hedge fund managers but I couldn't care less about them, tell me what the world's most influential allocators are doing with their asset allocation and then you have my attention.
Are they rebalancing out of stocks and into bonds? It's possible they took some profits but I don't think there is any major rebalancing going on even if stocks surged from their December lows.
So try not to panic about the inverted yield curve or the bond market's ominous warning, it's still too early to tell whether stocks are going to get clobbered again or if this is just another pullback before they keep grinding higher.
On that note, a look at the how the S&P sectors performed this week, courtesy of barchart (click on image):
As you can see, Financials (XLF) got slammed hard, down 5% this week.
And here are the top-performing US stocks for this past week, courtesy of barchart (click on image):
Again, a bunch of small cap biotech stocks nobody has ever heard of.
Also, here are the top large cap stocks year-to-date, courtesy of barchart (click on image):
Here, I see a lot of familiar names but no wonder almost all active managers are underperfoming again this year.
Anyway, hope you enjoyed my weekly market comment, try not to panic about the bond market's ominous warning. As always, please remember to support my work via a donation on PayPal on the top right-hand side under my picture. I thank everyone that supports my work, it's greatly appreciated.
Below, special counsel Robert Mueller on Friday delivered his report to Attorney General William Barr on Russia's election meddling and possible collusion with Donald Trump's presidential campaign. CNBC's Eamon Javers reports.
Second, CNBC's Mike Santoli and Rick Santelli break down what the yield curve may be signaling for the market and how a yield curve works.
Third, CNBC's "Power Lunch" team is joined by Ron Insana, CNBC contributor and senior advisor to Schroders North America, and Krishna Memani, chief investment officer with Oppenheimer Funds, to break down how the markets are reacting today as well as what the yield curve represents at this time.
Fourth, Tobias Levkovich, Citi chief U.S. equity strategist, discusses the market selloff and pressures on the economy with "Squawk on the Street".
Fifth, David Rosenberg, chief economist at Gluskin Sheff, talks his economic forecast with CNBC's "Closing Bell." I agree with Rosie, the Fed might be on hold but it raised rates nine times and we are only now seeing the lagged effects on these rate hikes in the economy.
Sixth, Danielle DiMartino Booth of Quill Intelligence says despite a broad positive outlook, there are still several troubling signs about the US economy. Danielle is a top economist, listen carefully to her analysis.
Seventh, Greg Daco, Oxford Economics chief U.S. economist, and Paul Hickey, Bespoke Investment Group co-founder, join 'The Exchange' to discuss the market plunge amid concerns on a global slowdown. Very good discussion, well worth listening to their views.
Lastly, former PIMCO strategist, portfolio manager, and Chief Economist Paul McCulley warned about the credit bubble years before it burst. He was interviewed by Consuelo Mack on WealthTrack stating: "The Fed is essentially done." Good interview, watch it below.
Interestingly, while Paul McCulley doesn't see a recession and thinks the Fed is done, in his Bloomberg article, A Recession Is Coming, And Maybe a Bear Market, Too, A. Gary Shilling thinks otherwise and says a soft landing will bring the Fed back in play:
There is, of course, a small chance of a soft landing such as in the mid-1990s. At that time, the Fed ended its interest-rate hiking cycle and cut the federal funds rate with no ensuing recession. By my count, the other 12 times the central bank restricted credit in the post-World War II era, a recession resulted.Take the time to read Shilling's entire comment here, it's excellent.
It’s also possible that the current economic softening is temporary, but a revival would bring more Fed restraint. Policy makers want higher rates in order to have significant room to cut in the next recession, and the current 2.25 percent to 2.50 percent range doesn’t give them much leeway. The Fed also dislikes investors’ zeal for riskier assets, from hedge funds to private equity and leveraged loans, to say nothing of that rankest of rank speculations, Bitcoin. With a resumption in economic growth, a tight credit-induced recession would be postponed until 2020.
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