Happy May Day! Despite the defensive posture the title of this post evokes, I am bullish on the US economy. And as a result, I am not bearish on risk assets, despite the flattening yield curve. I believe recession is not imminent. And as such, we have ample time to prepare our portfolios for an eventual bear market. Let me explain below.
The basics of the Treasury curve
I started talking about this yield curve flattening – where the premium investors receive for holding longer maturity Treasury bonds decreases – about six months ago. The gist of that post was that people were overly concerned about curve flattening. I am more concerned now at a 2-10 year Treasury spread of 45 basis points than I was at a 70 basis point spread in November. But the big takeaway from that post still holds: flattening is not inversion.
And to understand why, you have to look at the basics behind the curve. First of all, the Treasury market is the most dynamic and liquid bond market in the world. US Treasury Secretary Steve Mnuchin is right when he says it can handle the increased supply from the Trump deficits.
— Bloomberg Economics (@economics) 1 May 2018
Second, remember that US dollars are ‘fiat’ currency, US government IOUs backed by nothing but the US government’s power to tax, and enhanced by the US dollar’s role as the medium of exchange and sole legal tender in the United States. So think of the yield curve for Treasuries as setting a benchmark ‘price’ for the safest US dollar assets.
Now, the ‘price’ of these assets, reflected in their yield, is a combination of two things. There are the expectations of the future path of short-term Treasury yields and the Treasury term premium for the opportunity cost of holding a fixed assets without being able to reinvest your money.
And in a normal environment, longer maturity Treasuries have higher yields, at a minimum because of the term premium. But what’s normal? Inflation has been falling for years, so much so that deflation has been the bigger risk. And term premia reflect this.
See the 10-Year Zero Coupon Term Premium for example.
Source: St. Louis Fed
Yield curve flattening
So, what happens when expectations of the future path of short-term Treasury yields change?
Since long-term rates are just a mashup of future short rates plus a term premium, we should expect the yield curve to change. The yield curve steepens when expectations are for an increased level of future short-term yields. And the curve flattens when expectations for the level of future short rates decrease
Historically, what we have seen is that the yield curve inverts when market expectations for future short-term Treasury yields become extremely bullish. What that essentially means is that bond market participants are incredibly sure that the Federal Reserve will cut interest rates in the future. And so, their view of future short-term term rates causes long-term rates to drop. And long rates drop so much that the curve inverts.
That’s a bad omen economically. Why? The main driver of bond investor expectations is the Fed’s reaction to the economy and inflation. And so, if expectations for bonds are so bullish, the yield curve inverts, the Fed would have to be cutting rates pretty aggressively in the very near future. And the Fed only does that in a recession.
Correlation is not causation
Right now, we are at a level where 10-year rates are 45 basis points higher than 2-year rates. Worrying? Yes, but only because the Fed is signalling a whole slew of rate hikes to come.
The flattening yield curve is not an omen of bad news. The biggest equity bull market in decades occurred in the 1990s when the yield curve flattened to today’s levels. And the economic data today show full steam ahead in the jobs picture, in wages, in consumption and in output. Signs of a material slowdown are not entrenched.
So, just because the yield curve has flattened doesn’t mean recession is right around the corner. A flattening yield curve doesn’t cause recession. It doesn’t even mean the economy is about to decelerate. Last week, I argued the exact opposite could be true. What flattening does mean, however, is that the market perceives the Fed’s forward guidance as tightening. Flattening = tightening.
As I wrote in November, “the steepness of the yield curve is not a sign of impending economic acceleration or deceleration per se. Rather, the curve is an indicator of the market’s perception of the level of monetary accommodation.”
So we have a year to wait this out
If you look at the economic cycles of the last 40 years, you’re talking between 11 and 22 months between yield curve inversion and recession.
Source: St. Louis Fed
So I’ve talked about 12-18 months as a rule of thumb. I’m not saying 12-18 months between a flat curve and recession. I’m saying 12-18 months between inversion and recession.
That gives you at least a year to rotate your portfolio and get defensive. What we should be looking for is weakening credit and economic fundamentals that feed through into credit deterioration, defaults and poor corporate earnings. If these signs increase, markets will not ignore them as one-offs. And the bull market will end.
It was interesting to see Jeremy Grantham note something similar in January. When he posited his melt-up thesis, he showed data about being late to rotate versus being early. And the numbers — from 1929, from Japan’s bubble, from the tech bubble and from the housing bubble — showed that being late doesn’t penalize you.
What that effectively means is that rotating into emerging markets, as Grantham recommends one do eventually, can be put off. You don’t have to do it now because EM represents relative value as compared to an overvalued US market. When correlations rise to one in a liquidity crisis, EM is going to get hit hard. Perhaps EM will get hit harder than the US because of the currency risk and the hot money flows. Why would you rotate into EM now, if that’s what could be waiting for you? Something to think about
Last thoughts on flattening
Note that, as inflation has dropped, Treasury yields have benefited doubly, both from the drop in the term premium noted above and in inflation.
Source: St. Louis Fed
And that, in turn, has created a major bull market in bonds. And this bond bull has, in turn, helped increase all asset prices.
I don’t think end of business cycle inflation is sustainable. The forces of deflation are too large. They will swamp cyclical inflation during the next downturn. And inflation will drop. The risk of deflation will rise and the term premium will drop as a result. People will pile into safe assets, driving Treasury yields down.
However, if inflation comes roaring back in a sustainable way, the rout will be both in inflation and in the term premium.
On real yields, notice that they are holding steady.
Source: St. Louis Fed
I expect that dynamic to continue until a recession. And that means, we have to look for flattening in the term premium and in inflation expectations. In short, lower inflation expectations and a compressed premium will drive flattening. And that would be a bad omen the Fed would want to heed.