All posts by Charlie Bilello

Waiting For An Inverted Yield Curve, Waiting For Godot

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.

Predictive Power

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.

Godot1new

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.

Godot2

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.

Godot3

The Fed

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.

Godot4

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.

Godot5

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.

Godot6

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.

Godot7

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.

Godot8

Another similarity is the stagnation in real wages. This has been the weakest expansion in terms of real wage growth in history.

Godot9

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.

Bear Mkts WO Inversion - 8-27

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.

“Canceling Signals”

“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.

Bottom Line

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

Edward M. Dempsey Pension Partners New YorkCharlie 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.

You can follow Charlie on twitter here.

facebooktwittergoogle_pluslinkedinmail  rssyoutube

Related Posts:

  • No Related Posts

Seven Years Later: What Does the Fed Know?

Fed1

“This is about Bernanke. He has to be on that [Bear Stearns] call. Bernanke needs to open the discount window, that’s how bad things are out there. Bernanke needs to focus on this. Alan Greenspan told everyone to take a teaser rate and then raised the rate seventeen times. And Bernanke is being an academic. It is no time to be an academic. It is time to get on the Bear Stearns call. Listen, open the darn Fed window. He has no idea how bad it is out there. He has no idea! He has no idea! I have talked to the heads of almost every single one of these firms in the last 72 hours, and he has no idea what it’s like out there. None! And Bill Poole has no idea what it’s like out there. My people have been in this game for 25 years and they’re losing their jobs, and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! I have not seen it like this since I went five bid for a half a million shares of Citigroup and I got hit in 1990. This is a different kind of market, and the Fed is asleep. Bill Poole is a shame. He’s shameful.” – Jim Cramer, August 3, 2007

It’s hard to believe that it’s been seven years since the epic Cramer rant of August 2007. In my view, it was one of the most entertaining and fascinating pieces of financial television that you will ever see (click here for clip). The timing could hardly have been better.

It was Friday, August 3, 2007, two months before the ultimate stock market top. The S&P 500 had just closed below its 200-day moving average for the first time in a year, but was still up over 1% YTD.

Fed2

Financials were telling a much different story than the broader market as the start of the housing collapse had already begun. The largest financial firms had significant exposure to securities predicated on the belief, shared by the Fed and chairman Bernanke, that on a nationwide basis “housing prices never go down.” That belief was soon to be tested.

Fed3

“As Bad as I’ve Seen it in 22 Years”

Bear Stearns stock was plunging after a conference call was held to address concerns stemming from a rating agency action. Standard and Poor’s had changed its outlook for the firm’s bonds to “negative” from “stable.” Sam Molinaro, Bear Stearns’ CFO, compared the last six weeks in the market to the shocks of 1987, the Asian and Russian debt crises of the 1990’s, and the dot-com collapse. “These times are pretty significant in the fixed-income market,” he said. “It’s as bad as I’ve seen it in 22 years.”

Cramer was not happy with the call, saying: “Memo to Bear Stearns: you gotta adopt a Henry Ford attitude here, which is never explain, never complain. And they didn’t do that. You keep your mouth shut during this period, you don’t say a thing…I don’t want to create fear, I like Bear Stearns very much but I think that at this stage, this is not a good call. They shouldn’t have done it. And they should’ve just said you know what, we’re doing well and don’t say another thing.”

Cramer would go on to say that the Fed knows “nothing” about how bad the market environment was, imploring Bernanke to stop being an “academic” and to open the “Fed window.” He also went after Bill Poole, chairman of the St. Louis Fed, likely in response to Poole’s recent comments on the Fed’s role in the market. Poole had said that the “Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves.”

Cramer either disagreed with Poole’s hands-off theory or believed that financial market developments were already threatening “market processes.” In either case, he was adamant in saying that lower rates were necessary.

A month later, the Federal Reserve would comply with Cramer’s request, cutting the Federal Funds Rate from 5.25% to 4.75% on September 18, 2007. The Fed would continue cutting rates until December of 2008 when they moved the Fed Funds Rate down to 0%.

Cramer was prescient in his assessment of how bad things were in August 2007, which was in sharp contrast to the Fed’s still rosy outlook. What he and most other market participants likely did not appreciate was that lowering interest rates could not prevent what was to happen next. For it was not simply a liquidity issue; it was very much a solvency issue. Indeed, the Fed lowered the Funds rate from 5.25% to 0% and the S&P 500 declined 57% during that time period. If cutting rates were a panacea, surely this would not have happened.

Seven Years Later: What Does the Fed Know?

The Fed Funds Rate still stands at 0% today, more than five years into the economic recovery that began in June 2009. Financial conditions have normalized, deflation is no longer a legitimate concern, equity markets are at all-time highs, and yields on risky debt are at all-time lows. Why in the world is the Fed maintaining such an aggressive policy stance in spite of these facts? “They must know something” is the common refrain. With the unprecedented boom in all asset prices, market participants are equating short-term market performance with long-term economic insight.

Indeed, the same organization that missed (and whose policies encouraged) the internet and housing bubbles when they were right before their eyes is now being credited with having unique foresight into the future. I have a slightly different view.

Jim Cramer was correct. The Fed knew nothing about the health of the economy in August 2007 and from all the available evidence I can only conclude they know even less in August 2014. They maintain that quantitative easing and 0% interest rates are for the good of the economy but ignore evidence to the contrary that this has been the slowest economic growth and weakest wage growth recovery in history.

Fed4The Fed’s response is that they simply “need to do more.” Perhaps a fourth round of QE and another year of 0% interest rates will do the trick. But as I questioned in a recent piece, do more at what cost?

The Fed will never admit to it, but what they really do know a lot about at this point is not the economy, employment or real wages. What they know a lot about is how to blow bubbles. Indeed, they have likely already created the third financial bubble in the last fifteen years. They pretend to be totally oblivious to the relationship between 0% interest rates and rampant speculation, but we all should know better by now. Their accommodative policies and the “Greenspan Put” helped inflate the internet bubble. Their solution to its eventual bust was the creation of a housing bubble. And their solution to the housing crash was apparently to create an all-encompassing reach for yield and risk bubble, this time under the guise of a “wealth effect.”

When this bubble eventually bursts, we can expect the Fed to do more of the same: deny any culpability and try to inflate once again. Market participants and bad actors will indeed be counting on the latter part as the moral hazard has been firmly engrained by now. The only question in my mind is whether the majority will once again stand for it all, especially as the wealth gap has only widened during quantitative easing and 0% interest rates. As Stanley Druckenmiller has said, quantitative easing has been the “biggest redistribution of wealth from the middle class and the poor to the rich ever.” Indeed, households in the top 20 percent of U.S. socioeconomic groups saw their incomes grow by an average of $8,358 a year from 2008 to 2012, compared with a $275 annual decline for the lowest 20 percent, according to data from the Bureau of Labor Statistics.

Can this really be good long-term policy? And does a policy focused on the creation of bubbles and crashes really promote the Fed’s “dual mandate” of maximum employment and stable prices? I think we all know the answer to these questions but as we’re mesmerized by rising asset prices, we remain silent. Only after a sharp decline will we start pointing fingers, but again, most will be looking for the Fed to do more, not less at that point. With the end of QE coming at the end of October, the debate may come sooner than most think.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie 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 on Intermarket Analysis. 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.

You can follow Charlie on twitter here.

facebooktwittergoogle_pluslinkedinmail  rssyoutube

Related Posts:

No Bubble, No Problems?

There’s a recurring theme emanating from nearly every permanently bullish pundit right now. I’m sure you’ve heard it. It goes something like this: “I was around in 1999-2000. You have no idea how crazy it was back then. We are nowhere near that level of mania today. We therefore have much, much further to go.”

On its face, it seems like a reasonable statement. After all, 2000 was the peak of the greatest U.S. stock market bubble we have ever seen. A chart of the CAPE ratio (or Shiller P/E) illustrates just how stretched valuations were back then and how we’re  still far from such levels today.

bubble1

The issue, though, is that every Bull Market doesn’t go through a 2000-like bubble before it becomes a problem. Since 1929, there have been twenty Bear Market declines in the S&P 500 (roughly one every 4-5 years). Only one of these was preceded by our collective definition of a bubble.

Bears4

Therefore, to argue that stocks are a good buy today and can’t go down because they have not yet reached the extremes of the greatest bubble in history is to argue two things. First, that there is a high probability of a similar bubble occurring, and second, that you have the ability to time your exposure to the bubble to insure that you get out before it inevitably bursts.

Today, many would argue on the first point that the probability of a similar bubble occurring is indeed high. After all, the Federal Reserve seems to want this outcome as they have maintained the loosest monetary policy in history five years into the recovery. If market participants are correct and the Fed does not raise rates until next July, it will be six and half years of zero percent interest rates at that point. Investors tend to do highly irrational things when money is this cheap. Thus, while I would not go as far as to say the odds of another dot-com like bubble are high, we cannot entirely rule it out.

What I would argue strongly against, though, is ability of the majority investors to effectively time their exposure to such a bubble. If history is any guide, most investors will not fare well as they have a strong tendency to buy high and sell low.

As we are approaching the 90th percentile of historical valuations (CAPE above 26), make no mistake about it, investors getting in here with hopes of another 1999-2000 bubble are indeed buying high. No, not as high as 1999-2000, but high enough where they should be expecting significantly below average returns over the next 7-10 years.

bubble3

Bottom Line

The permanently bullish camp is correct. It is not 1999-2000.  If that makes you feel better about buying stocks here, great, but it is not an argument based on logic.  As we saw in 2007, just because it is not a once in a hundred years bubble, it doesn’t mean there is no risk of a significant market decline. It also doesn’t mean that valuations are compelling and that investors should be expecting above average long-term returns from here. They should not. Something to think about the next time someone tells you a story about how this mania pales in comparison to the epic dot-com bubble.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

 

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie 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 on Intermarket Analysis. 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.

You can follow Charlie on twitter here.

facebooktwittergoogle_pluslinkedinmail  rssyoutube

Related Posts:

  • No Related Posts