Thursday, March 28, 2019

Yield Curve Inversion Occurs - But Is Anyone Paying Attention?

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Fed chief Jerome Powell and yield curve for March 25, 2019 (from T. Rowe Price Investor Bulletin, December, 2018)

For some time now, over the past 4 months, I've warned of potential yield curve inversion and how it's often signaled recession or massive downturn  I noted recessions tend to occur once the "flat" yield curve becomes "inverted" - with short term (e.g. 2 -year)  bond rates higher than long term (e.g. 10 year) rates. As a recent T. Rowe Price Investor Bulletin warned (p. 4) this condition has transpired before each of the past nine recessions dating back to 1955.  Hence, while it isn't a 100% absolute predictor, it is a significant historical marker..

The T. Rowe warning - assuming one can take it as such - is (ibid.):

"The yield curve is not flat yet ...but it could be by next March if the Fed maintains its 0.25 percent per quarter pace of rate hikes and the 10-year Treasury continues to meet resistance above the 3.0 percent level.  Starting the historical average 16-month clock from the spring of 2019 would raise the specter of a major downturn by 2020."


Interestingly, last Thursday we learned (WSJ, 'Treasury Yields Tumble After Fed Restraint', p. B12)  that "the yield on the two year Treasury notesettled at 2.402% on the day before compared with 2.471 % Tuesday. This marked the biggest one day slide since the start of the year, according to Dow Jones Market data."

 Given what happened March 21st, it shouldn't have been totally surprising the yield curve might actually have inverted on Friday - March 22nd - which it did.   One of my favorite go-to financial forecast sources, James Mackintosh in the Wall Street Journal wrote:   

"The market’s most reliable recession indicator is finally flashing red. With the Treasury yield curve inverting on Friday—the 10-year yield fell sharply to be lower than the three-month for the first time since 2007—is it finally time to prepare for an economic downturn?

Good question! I believe so, as I've written before given I suspect the correlations over time (see graphic are almost as reliable as sunspot activity curves in predicting large flares.   It is therefore of interest to inspect the yield curve for March 25th, with Treasury bills designated along the abscissa, e.g. with bond terms from less than five years to 30.  Note also the curve behavior and how it changes with the specific bonds.
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Look carefully and you will see the evidence for yield curve inversion, rates, hence the freak out for may. Subsequently economist and NY Times columnist Paul Krugman wrote the following in a tweet:
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Mackintosh, for his part, has always been somewhat agnostic on the value of the yield curve as forecaster of recession. He writes, for example:

The yield curve might be less reliable than its recent U.S. history suggests. It has a terrible record internationally, for instance. It flat-out hasn’t worked in Japan, also has a poor record in the U.K. and in Germany provided no advance warning of the 2008 recession, the worst since reunification. At the moment the curve isn’t inverted in any of them thanks to superlow or negative interest rates, even though all are struggling with greater economic troubles than the U.S.


In other words, one needs to bring to bear skepticism as to the historical evidence.

But then in subsequent text  we behold some very crucial points:

Previous inversions took place at much higher short rates — 5 or 6 percent, versus 2.5 percent now.”

He continued: “So this inversion actually reflects a worse outlook for the economy than the number itself suggests. Again, it’s not a direct read on the economy; it’s a read on what the average bond investor thinks is happening to the economy. But still not encouraging.

We should also bear in mind what Mackintosh wrote back on July 3, 2017, as regards the assumption that bear markets only come with recessions, i.e.:

"Investors believe that bear markets only come with recessions, and so reassure themselves that there is no sign a recession is imminent, repeating the mantra that 'economic cycles don't die of old age'. Unfortunately, this is both wrong and useless.

First, 20 percent drops happen outside recessions, as in 1987 and 1966. Second, economic cycles can be killed by a financial crash, and as the late Hyman Minsky pointed out, the longer a financial cycle goes on, the more likely it is to turn to excess and end badly. Worse, there is no reliable method of forecasting a recession, so even if it were true that only a recession can end a bull market, that isn't a lot of use to investors."

Put aside yield curve inversion, as yields fell and the curve merely flattened, "investors punished bank stocks ... A flatter yield curve hurts banks stocks because it narrows the gap between what lenders pay on deposits and lend on loans- a spread known as the net interest margin."  (WSJ, Mar. 22,  p. B10 ).  What especially bothered me even earlier (than seeing the yield curve inversion) was reading WSJ columnist Greg Ip's March 21  warning piece:



The Fed's New 'Normal' Looks Worrisome - WSJ




And how we needed to be wary of the Fed's sudden dovish inclination. Quoting Mr. Ip, which I believe is important to get the context:

"The Federal Reserve now believes its monetary policy is back to normal. That should worry you.  If this is normal then the Fed has precious little ammunition for when economic conditions again turn abnormal."

Ip then goes on to note that since 2005 the Fed had been 'normalizing' monetary policy by raising interest rates and shrinking its bond holdings."  (From the quantitative easing or QE policy.)

But:   "This week it declared the process all but done"  Adding to this,  the Fed big wigs see "no more rate increases this year"  and "they will stop shrinking the balance sheet".   This is nothing short of mind boggling, given almost $4 trillion of toxic bond assets remains on its balance sheets.   Even by September the bond balance will only be down to $3.5 trillion or 17 % of GDP.

Also, ceasing to increase interest rates puts the screws to millions of senior savers - who'd been saddled with pathetic low rates for over a decade. As one of the few segments of the ordinary citizen financial demographic with money to spend, this is not a sound move.   Ip also warns  (ibid., this is all from the original print version, not the digital update):

"Should the economy stumble again, the Fed won't have much ammunition with which to respond."

Well, unless it resorts to the "negative interest rate'"  route which the Swiss also attempted with adverse results, and millions actually stuffing money (cash) under their mattresses. I mean, who the hell wants to keep it in the bank and lose $$?

But perhaps there is method to the Fed's madness. As James Piereson writes ('How Debt Makes The Markets Volatile',  Feb. 28, p. A17):  "Stocks are becoming more sensitive to interest rate hikes because the global economy is over-leveraged."

Something I've also addressed before, in conjunction with IMF warnings and : 

"Vitor Gaspar, the director of fiscal affairs at the  IMF, singled out the U.S. for criticism, saying that it was the only advanced country that was not planning to reduce its debt pile - with the recent tax cuts keeping public borrowing high.  

The fund urged policymakers to stop 'providing unnecessary stimulus when economic activity is already pacing up' and called on the U.S. to 'recalibrate' its fiscal policy and increase taxes to start cutting its debt." 

So no, the GOP-Trump tax cuts - which effects are driving millions crazy now in terms of low or  no tax refunds -  did not help the situation. Assorted experts have estimated $1.5- 2 trillion in added deficits. And as the WSJ's Gerald Seib put it (Feb. 19, p. A4): "As the accumulated debt rises, the bill to pay the interest on the debt rises too."   See e.g.


Brane Space: IMF Debt Warning Ought To Send Chills Through Every ...





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