We Have Inversion (Sort of)

It’s been an interesting week thus far for the capital markets. On Monday we saw a rally in stocks in response to perceived progress in trade negotiations between the US and China. On Tuesday those stock gains evaporated, and then some, as investors reconsidered the extent of the progress. But the more interesting action may have occurred in the bond market. On both Monday and Tuesday investors continued to pour money into long-term Treasury bonds. As a result of the recent surge in demand, the 10-year Treasury bond continued a trend that has seen its yield drop by 0.33% to 2.91% from a 7+ year high of 3.24% on November 8. Over that same time frame, the yield on the 2-year Treasury bond dropped a much more modest 0.17% to 2.79%. The net effect has been a sharp decrease in the yield spread between the 2-year Treasury and 10-year Treasury to the lowest level since the eve of the Great Recession in 2007. As it currently stands, investors will only receive 0.12% more for lending their money to the federal government for 10 years as opposed to 2 years. And the yield on the 5-year Treasury is now slightly below the yield on the 2-year Treasury – a situation referred to as yield curve inversion.
This “flattening of the yield curve” is receiving a lot of attention in the financial press because “yield curve inversion”, a situation whereby short-term Treasury bonds offer higher yields than long-term Treasury bonds, has been one of the most reliable predictors of recessions in the past. In other words, many investors believe that the Treasury bond market, which is both deep and liquid, is the best place to find clues about the future direction of the economy and markets. Therefore, it is important for investors to understand the various factors that can drive demand for Treasury bonds.
So what are some of the factors causing long-term Treasury yields to fall, and why are yields on longer-term bonds falling faster than those on shorter-term bonds? While there are countless possible explanations, we see the following as most likely:
  • Economic growth appears to be slowing, and possibly in significant fashion. In particular, recent increases in interest rates (and decreases in affordability) have caused significant slowing in the housing market and other rate-sensitive sectors.
  • Investors may be fearful that the Fed is making a policy mistake by continuing to raise short-term interest rates in the face of clear indications of slower economic growth. We think these fears have been compounded by the following: 1) We are now in trade-war “limbo” following the announcement that the US and China will try to work out an agreement over the next 90 days; and 2) Fed Chairman Powell and the rest of the Fed may try to establish their independence by continuing with rate hikes in the face of public comments by the president that he’d like to see a pause.
  • Inflation appears to be falling again after finally reaching the Fed’s target of 2%. The Fed’s preferred inflation indicator is the core Personal Consumption Expenditures (PCE) deflator, which excludes food & energy prices.This metric has been trending downward over the past 3 months. The disinflationary trend appears to be confirmed by recent decreases in key industrial commodities like oil, copper, and lumber. (It should be noted, though, that a sizeable increase in the dollar has exacerbated the downward move in commodity prices, making the predictive power of falling prices less clear.)
  • There remains significant uncertainty with regard to the trade negotiations with China. President Trump’s twitter declaration on Tuesday that “I am a Tariff Man” did nothing to improve sentiment. If current tariffs remain in place or new tariffs are implemented, the drag on the economy could be significant.
  • Economies outside the US have clearly been slowing since the beginning of the year. The relative weakness in European economies, for instance, has kept interest rates comparatively low in that region. Low interest rates in Europe provide investors an opportunity to engage in arbitrage by buying US Treasuries and shorting German bonds, for example (if they are willing to assume the currency risk).
  • Higher interest rates have made bonds more attractive to stocks, which has resulted in the rotation of money out of stocks and into bonds. The renewed volatility in the stock market, and the rising number and intensity of geopolitical risks, have only increased the relatively attractiveness of bonds compared to stocks. This “flight to quality” has definitely been a factor in rising bond prices (and falling yields) in recent weeks.
  • There are technical issues contributing to the increase in demand for longer-term Treasuries. Many hedge funds and other investors had been short Treasuries to take advantage of an expected rise in interest rates. When that didn’t materialize, some investors were left scrambling to cover their short positions, contributing to a drop in yields

Source: Bloomberg
 
 What is perhaps most interesting about the recent drop in Treasury yields is that it is happening at a time when the supply of Treasury is expected to surge. The large supply of Treasury bonds hitting the market is the result of a surge in budget deficits, the need to refinance huge amounts of maturing bonds, and efforts by the Fed to decrease the size of its bond portfolios. The drop in yields in the face of rising supply only makes the trend more impressive and ominous.

Last week’s dramatic stock market strength in the face of falling yields was somewhat puzzling. In normal times (which we don’t know exist anymore!), big upward moves in stock prices would likely be associated with bond market weakness (rising yields), and vice versa. Last week, though, stock and bond prices rose together. The strength in stocks could have simply represented a bounce from sharply oversold levels during the prior two weeks. In any case, the ongoing drop in Treasury yields, and corresponding flattening in the yield curve, are beginning to take their toll with regard to investor sentiment. If bond market trends continue, it could be a rough road ahead for stock investors. But this outcome is far from certain. Therefore, we remain invested but advise a continued cautious and somewhat defensive posture.