Two sell-side strategists are waiting on a country road by a tree. What are they waiting for? Yield curve inversion.
Why are they waiting for it? They explain: “it has a flawless track record, predicting every U.S. recession in the past fifty years.” As recessions tend to be bad for the stock market, and the yield curve is not currently close to being inverted, the sell-side strategists are extraordinarily bullish. “We have many more years to run,” they agree, “both in the economy and the stock market.”
Let’s examine this thesis.
An inverted yield curve has indeed been an early warning sign of an oncoming recession. The past nine recessions in the U.S. were all preceded by yield curve inversion, with an average lead time of 14 months.
Note: In this analysis I am using the difference between the 10-year yield and 1-year yield as the measurement of the yield curve. Other commonly used short-term rates are the 3-month and the 2-year.
As we know, though, the stock market also tends be a leading indicator of oncoming recessions. Thus, for yield curve inversion to be a market signal it is important that the inverted yield curve not only lead the economic turn but also the turn in the stock market.
As the table below indicates, this is more often than not the case. In the past nine recessions, yield curve inversion has preceded the stock market peak six times with an average lead time of 7 months. Most recently, we saw the yield curve invert in January 2006, well in advance of the stock market peak in October 2007.
Yield Curve Today
As of the end of July, the spread between the 10-year Treasury yield (2.54%) and 1-year Treasury yield (0.11%) was 2.43%. At 2.43%, the yield curve is far from inversion, supporting the argument of the sell-side strategist.
The problem with this simple interpretation, though, is that current Federal Reserve policy is unlike any of the prior recoveries in which the yield curve eventually inverted. The difference is glaring when looking at the chart below. We are now over five years into the recovery that began in June 2009 and the Federal Funds Rate remains at 0%-0.25%, the same level it stood at in December 2008. This is by far the longest period of time the Fed has left the Funds Rate at a trough level following a rate-cutting cycle and new economic expansion.
Manipulating the Curve
By holding short-term interest rates near 0%, the Fed has effectively made it impossible for the yield curve to invert. With the 1-year Treasury yield at 0.11%, for the curve to invert the 10-year Treasury yield would have to cross below this level, an unlikely event. The table below illustrates that the average Effective Federal Funds Rate at the time of prior yield curve inversions was 6.16%, and the lowest Funds Rate at inversion was 2.94% back in 1956. At a 0.09% Effective Funds Rate, we are far from such levels today.
Still, most will argue that if the Fed has the ability to prevent a yield curve inversion then they have the ability to prevent recessions and bear markets. Fair enough assumption, but…
Then There’s Japan
The Bank of Japan has held their discount rate near 0% for nearly twenty years, since 1995.
While this has been successful in preventing an inverted yield curve, it has been less successful in preventing recessions as can be seen in the chart below. Japan has experienced recessions time and time again since 1995 in spite of 0% rate policy.
But “We’re Not Japan”
The counter to the Japan example is the simple statement that “we’re not Japan.” This is certainly true as there are many differences in our economies and we are not fighting outright deflation as our demographic issues are not nearly as troubling as in Japan.
Still, while we may not be exactly like Japan, there are a number of similarities. Most important among these is that our central bank seems to believe that we are very much like Japan as they are following the same monetary policy. Both in terms of endless balance sheet expansion through quantitative easing and extended zero-interest rate policy, we look very much like Japan.
We also look like Japan in that growth during this recovery has been the weakest in history, hovering between 1-2% per year.
Another similarity is the stagnation in real wages. This has been the weakest expansion in terms of real wage growth in history.
Still, you remain unconvinced. Japan may have had multiple recessions/bear markets without a yield curve inversion, but we’re different. Perhaps, but…
You Can Have a Bear Market Without An Inverted Yield Curve
The stock market is not the economy and vice versa. While an inverted yield curve has tended to precede stock market weakness, you don’t need an inverted yield curve to have stock market weakness. There have been five bear markets without any yield curve inversion or recession, most recently in 2011.
You can also have an inverted yield curve without a recession, as we saw in December 1965 through February 1967. There was, however, a bear market during that time, from February 1966 through October 1966 when the S&P 500 declined 23.7%.
Waiting for Godot
In the famous absurdist play “Waiting for Godot,” the two main characters (Vladimir and Estragon) wait endlessly for a man named, you guesses it, “Godot.” Needless to say, Godot never arrives.
In today’s markets, we have a similar parallel where most strategists and economists are waiting for yield curve inversion before they take a more cautious or defensive stance. However, as long as zero-interest rate policy continues, yield curve inversion is unlikely to arrive. They are likely to keep waiting.
Does that mean that U.S. equity markets are without risk?
Certainly not, though this seems to be the consensus these days. First, we have the example of Japan that has not changed its interest rate policies in twenty years but has had multiple recessions and bear markets during that time. Second, we know that even in the U.S. we have had multiple bear markets (as recently as 2011) without yield curve inversion. Thus, risk still remains but a yield curve inversion is simply unlikely to signal it this time around.
“This is a big, big gamble to be manipulating the most important price in free markets, interest rates. These purchases are canceling market signals. The bond market and the stock market have provided wonderful signals for many years as to potential problems. And when you cancel those signals, you could run into a problem. I don’t know when it’s going to end, but my guess is it’s going to end very badly.” – Stanley Druckenmiller
You simply cannot analyze today’s markets with an indicator like yield curve inversion because the Fed is doing something they never did before: holding rates at 0% for over five and a half years. Economic theories that explain how yields vary with maturity have been rendered irrelevant. The liquidity premium theory? Throw it out. The market segmentation theory? Forget it. The preferred habitat theory? Useless. The Pure expectations hypothesis? Unusable.
The reason why an inverted yield curve is predictive of economic weakness is that long-term bond investors will settle for lower yields if they start to believe the economy will slow or decline in the future. They accept lower yields in because they believe short-term rates will fall as the real demand for credit weakens during a recession and the Fed starts cutting rates. Locking in a lower yield on a 10-year bond than what you could earn on 1-year bond makes economic sense if you believe that when the 1-year bond matures the rate you can reinvest at will be much lower.
In today’s market environment, you already have short-term rates at 0%, so market participants cannot assume that the Fed will lower rates if economic weakness ensues. The most that they can assume is that the Fed will simply keep rates at 0% for a longer period of time. This would in turn drive demand for longer-term debt, leading to a flattening, but not outright inversion, of the yield curve.
This is precisely what has been occurring all year in 2014, with the yield curve flattening. It won’t lead to inversion because investors are unlikely to accept 0% on a 10-year bond, no matter how bad they expect future economic growth to be. We have seen this in Japan which has experienced multiple recessions without the 10-year yield moving below the 1-year yield.
The implications for investors and markets today are as follows.
1) As long as the Fed is operating under 0% policy, yield curve inversion is not a valid risk management signal as inversion is essentially impossible. What would the yield curve look like today if the Fed had normalized policy years ago as they did following every other recession in the past fifty years? Would the yield curve already be inverting here? We simply don’t know.
2) It remains to be seen what occurs first, a change in Fed policy or economic weakness. Most are assuming the former, where the slow growth expansion continues and the Fed starts raising rates next July. At that point, market participants are expecting the Fed to slowly raise rates and the yield curve inversion signal to eventually come back into play years later, signaling future economic weakness. While this is certainly one scenario, it is not the only scenario. If the latter (economic weakness) occurs first, we could be looking at a Japan scenario of a recession/bear market during an extended period of low interest rates. Most investors consider this scenario unlikely but it is something we should at least be considering.
3) In any case, the idea that equity markets are currently risk free because the yield curve is not inverted is not supported by history, most recently in 2011.
4) As long as ZIRP remains in place, investors would be wise to look beyond yield curve inversion for guides to risk management and asset allocation. At Pension Partners, we authored two award-winning papers in 2014 that focus on the unique behavior of the utilities sector and Treasuries as indicators of increased volatility and risk in the market. These signals are used in our mutual funds and separate accounts where we employ a quantitative investment and risk management process. Importantly, these signals are not reliant on yield curve inversion.
5) Regardless of the shape of the yield curve, for the reasons outlined in “Has The Fed Doomed Buy And Hold,” I believe the environment going forward is likely to favor more tactical strategies over buy and hold. I also believe that risk management is likely to be a more important factor as we approach the end of QE3 in October (see “The Fed Prisoner’s Dilemma”).
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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