Happiness Is a Normal Yield Curve
“I never liked quantitative easing. Flattening the yield curve is
not stimulative; flattening the yield curve is anti-stimulative.”
– Ken Fisher
“There is a limit to how much the United States Treasury can
borrow.”
– Alan Greenspan
“In other words, we have the models we have because of inertia and
theology, but also because all we can do is all we can do.”
– Kit Webster
“[T]he specific manner by which prices collapsed is not the most
important problem: A crash occurs because the market has entered an unstable
phase, and any small disturbance or process may have triggered the instability.
Think of a ruler held up vertically on your finger: This very unstable position
will lead eventually to its collapse, as a result of a small (or an absence of
adequate) motion of your hand or due to any tiny whiff of air. The collapse is
fundamentally due to the unstable position; the instantaneous cause of the
collapse is secondary.”
– Didier Sornette, French geophysicist
Photo: Paul Kelly via Flickr
Once again I start this letter with a warning: A recession is
eventually coming and a financial crisis with it. There is a real potential for
it to come soon, as in the next year or two, although serious tax reform could
change that equation. But at the end of the day, the pressures of too much
government debt and too many government promises, plus growth that is
continually grinding slower, will result in a recession.
There is always
another recession. You can’t run your life and business as if you expect one to
happen tomorrow, but you can make contingency plans. With each passing day,
recession gets closer, but that’s no reason to be fearful if you’re prepared.
I’m not trying to sound like an Old Testament prophet – OK, so
maybe I am – but this is serious. Many business owners aren’t ready, nor are
many portfolio managers and individual investors. They will likely regret their
inattention.
Today I will show you a simple indicator that has an excellent
recession-forecasting record, according to research by the Federal Reserve
itself. Though the Fed’s own wacky policies may have weakened this
early-warning system’s reliability, an interpretive adjustment can restore its
usefulness.
First, thought, let me give you yet more reasons for concern on a
completely different front. We have been getting complaints from readers that Thoughts from the Frontline
is no longer showing up in their inboxes. We have cornered the problem, and its
name is Google.
Google’s Gmail creates categories to characterize emails that are
sent to your inbox.
They are trying to route all newsletters directly into a
dedicated folder (I believe they even call it “Promotions”), instead of sending
them through to people’s inboxes.
There is not much we can do about it at this
point. I’m on the hunt for an email delivery specialist who can help us with
what is now being called “inboxing.” This problem is industrywide. If you
are using Gmail, you might want to check to see where the emails that you want
to read are actually being routed.
The industrious Michael Lebowitz of 720Global
performed an invaluable service last week by assembling “22
Troublesome Facts” behind his reluctance to follow the bullish herd. Most
have helpful source links, too. Here’s a small sampling:
• The S&P 500 cyclically adjusted price-to-earnings (CAPE)
valuation has only been higher on one occasion, in the late 1990s. It is
currently on par with levels preceding the Great Depression.
• Total domestic corporate profits (w/o IVA/CCAdj) have grown at
an annualized rate of just .097% over the last five years. Prior to this period
and since 2000, five-year annualized profit growth was 7.95%. (Note: Period
included two recessions.)
• Over the last 10 years, S&P 500 corporations have returned
more money to shareholders via share buybacks and dividends than they have
earned.
• At $8.6 trillion, corporate debt levels are 30% higher today
than at their prior peak in September 2008.
• At 45.3%, the ratio of corporate debt to GDP is at historical
highs, having recently surpassed levels preceding the last two recessions.
So, US corporations are simultaneously more indebted, less
profitable, and more highly valued than they have been in a long time.
Furthermore, they are intentionally making themselves more leveraged by
distributing cash as dividends and buying back shares instead of saving or
investing that cash. Yet investors cannot buy their shares fast enough. Maybe
this will end well… but it’s hard to imagine how.
The once-foolproof recession indicator I mentioned up top is the
Treasury yield curve. It has allowed me to predict the last two recessions. The
yield curve is simply a chart showing Treasury yields on the vertical axis and
maturity on the horizontal axis. Below is how it looked at mid-year 2017,
courtesy of the US Treasury’s website.
You can plot other dates here.
Bond traders keep a close eye on the yield curve, and especially
on changes in its shape. The curve above is fairly normal. Other things being
equal, you expect interest rates to slope upward as time to maturity increases.
That’s because lenders demand higher rates to compensate for the higher risk
that comes with lending money for longer periods. The longer you let a borrower
hold your cash, the greater the chance something bad will happen to it.
The yield curve’s angle is important, too. It gets steeper when
lenders perceive greater risks to long-term loans because, for example, they
expect inflation to rise. It’s flatter if inflation risk seems low.
Now, compare the one above with the yield curve of Nov. 30, 2006.
Note that yields across the whole curve were higher than they are
now. More importantly, the curve is inverted,
meaning the short end is actually higher than the long end. At that point
investors demanded higher yields for 1-month loans than they did for 30-year
loans.
The inverted yield curve historically shows up only when the
economy is in recession or soon will be. An inverted yield curve doesn’t cause
a recession but does indicate unusual stress in the market. Lenders presume the
Fed will reduce rates soon, so demand increases for longer-term bonds whose
rates are locked in. High demand pushes their prices higher and yields lower.
The opposite happens at the short end, so those rates rise, and the curve
flattens or inverts.
The inverted yield curve is a classic recession indicator. It
inverted in early 2000, right after the Y2K scare proved unfounded and the
dot-com bubble was starting to burst. It inverted again in 2006–2007.
A 1996 New York Federal Reserve Bank study looked at the spread
between 90-day and 10-year Treasury yields and found that an inversion preceded
every recession of the modern era. That Fed study built on earlier research by
economist Campbell Harvey, who is now at Duke University. Not every inversion
signaled a recession, though. The study actually goes into the probability of a
recession depending on the depth of the inversion and the length of time the
yield curve is inverted. Typically, by the time a recession starts, the yield
curve has a normal slope. Also typically, an inverted yield curve of the proper
depth and duration suggests that a recession is due in about 12 months. I find
the research fascinating, and you can read more about it in my
December 30, 2005 letter.
The same authors also did an analysis of 20 different leading
indicators. The only indicator that had any true reliability in predicting
recessions was the inverted yield curve. While other measures and signals may
be useful, they either provided false predictions or failed to recognize a
coming recession.
Now, since the yield curve is not presently inverted, why am I
worried? Because it no longer tells us what it once did.
Look again at the June 30 yield curve. Now, let’s roll forward to
July 20. Direct your attention to the red arrow, where we see a slight
inversion forming.
On that day, the 3-month Treasury yield exceeded the 6-month
yield. It still does today. Why would that be? Well, yields rise (and prices
fall) when supply exceeds demand. So fewer people seem to want those 3-month
bills.
When is three months from July? That would be October, when there
is a fair chance that the US will be embroiled in another
debt-ceiling/government-shutdown scenario. T-bills maturing in that period face
a slight risk of delayed payment. The odds are low but still enough to show up
in T-bill yields.
Joe Wiesenthal at Bloomberg illustrated it another way in the
chart below. During the 2013 debt standoff there was a spike down in the 6-month/1-month
Treasury spread. Now we see the same in the 6-month/3-month spread.
Keep in mind that US Treasury bills are probably the most liquid
fixed-income instruments on the planet. Few markets are more efficient than
this one. Generating this kind of outlier spread isn’t easy, but our crazy
political situation is doing it. Peter Boockvar considers this inversion as
noise that will pass when (we hope) Congress raises the debt ceiling and
repayment risk again drops to zero.
More interesting, Peter believes that years of artificially capped
short-term rates have changed how the yield curve works. He thinks the short
end tells us little about economic prospects. He watches the spread between
5-year and 30-year Treasury yields. It has dropped considerably in the last
year but is still a long way from inverting.
That’s small comfort. It probably means recession isn’t right
around the corner, but it is likely still coming, and this week’s FOMC
statement indicated they still plan to tighten policy, even as growth remains
stalled. We will likely see fed funds hikes in September and/or December. The
FOMC also said that the balance sheet reduction plan will commence “relatively
soon.” I think that probably means September, but we’ll see.
By the way, let me publicly thank Peter Boockvar for giving us a
new buzzword. The Fed called its bond-buying program, from which it is now
trying to exit, “quantitative easing” or, in today’s GDP numbers release, “QE.”
Those simple initials have saved me and other writers untold millions of
keystrokes. But what do we call the ending of QE? The FOMC statement refers to
it as “balance sheet normalization.” That’s too long.
Peter says this is very simple. The opposite of easing is
tightening, so the opposite of QE is QT: quantitative tightening. He likes this
shorthand also because it stresses what the Fed wishes to disguise: Reducing
its balance sheet really is tightening. QT will remove stimulus and make
borrowing more expensive and difficult. So spread the word: QT is coming.
I can understand why the FOMC feels the need to normalize rates
before handing the baton, no later than the middle of next year, to what will essentially
be the Trump Federal Reserve Board. But I am totally mystified as to why its
members feel the need to reduce the Fed’s balance sheet at the same time.
Percentagewise, the Federal Reserve increased its balance sheet dramatically in
the 1930s. Then they left it there. Eventually the balance sheet became
relatively small again as the economy grew.
I see no reason to hit the market with a double whammy when simply
raising rates at the short end will be adjustment enough. If for some reason
inflation rears its head, the Fed can fire up QT. In today’s GDP numbers
release, however, the Fed’s favorite measure of inflation was a mere 1%.
Annualized second-quarter GDP growth was estimated to be 2.6% after adjusting
for inflation. Nominal annualized GDP growth was 3.6% when 4% was expected. I
scratch my head wondering why the Fed feels driven to fight inflation that is
not showing up in the data.
As Lacy Hunt said in this week’s Outside the Box, there is a slavish regard at
the Fed for the Phillips curve, the theoretical link between wages and
employment. The theory says that with unemployment levels as low as they are,
we should be seeing more inflation, so the Fed wants to make sure they keep
ahead of the curve. However, both the way they measure inflation and the way
they measure employment have significant problems and errors. When so many
people who out of work are not officially listed as unemployed (and thankfully
last month we saw some of them actually begin to come back to the workplace),
the headline unemployment number is highly suspect, if not downright
misleading.
We are clearly late in the business cycle, and the Fed is asking
for trouble with its tightening policy. It risks making a monetary policy error
– one of the major causes of recessions.
My friend Kit Webster and I were talking recently about the
futility of using mathematical models to predict the future of an economy so
complex as to defy modeling. Fed economists interpret flawed models like the
discredited Phillips curve (which both Volcker and Greenspan panned) with a
faith tantamount to religion, like modern-day shamans and witch doctors mulling
sheep entrails. Just as economists believe models that repeatedly fail to make
accurate predictions, many of us in turn choose to believe our high-priest Fed
economists. After all, we want to believe that somebody knows what’s going to
happen.
Back to the yield curve and its ability to predict a recession.
The Federal Reserve’s tampering at the short end of the yield curve has
rendered this traditional predictive device useless. We have to adapt. With
that in mind, it’s important to note that the 5-year/30-year yield spread has
been tightening coincidentally with a slowdown in GDP growth from already low
levels. There is the potential for a move from where the curve is now to
inversion within a year. Attention must be paid. An outright recession would
likely follow, but we’ll feel a downdraft whether the data fits the formal
criteria or not.
It’s tough to state that there will be another recession without
having the tools to really give a firm prediction. We just don’t have enough
good research; so we must be more vigilant, especially in this time of
stretched valuations and market sensitivity.
The good news: The yield curve can still be our early-warning
indicator, with the proviso that we ignore the short maturities and watch the
5-year/30-year spread or maybe even the 5-year/20-year. You can monitor this
yourself by checking T-bond yields on most financial news sites. Find the
30-year yield (or 20) and subtract the 5-yield from it. Right now, the
difference is around 1.1 percentage points. The lower it goes, the closer
recession may be.
My Swiss friend Alexander M. Ineichen of Ineichen Research &
Management AG conducts a massive amount of research each month on momentum in
markets all over the world. He recently analyzed how momentum models looked
like prior to the last two recessions, before and after the peaks. Then he
compared what he found to our situation today. His work is too lengthy and
chart-rich to reproduce here, but I can give you a link to it and share at
least one chart and his take on what I call “peak complacency.” You can see the
latest report, titled “Peaks,” in his sample materials here. Quoting:
Risk: Most risk gauges imply, if anything, investor complacency.
VIX, for example, has been single digit a couple of times over the past months,
a rarity. It was single digit at the Nasdaq peaks since mid-July. VIX was at a
new all time low at 9.04 when finishing this document on 25th July. Figure 19
shows one way of measuring investor complacency. Chart shows trailing P/E ratio
of S&P 500 divided by VIX, i.e., implied volatility. The higher the ratio,
the more complacent is investor sentiment. Currently, there is no fear.
Risk happens fast. It happens even faster in a complacent
market. Pay attention…
As I write, I find myself in yet another hotel room, getting ready
for meetings. Shane and I will enjoy a getaway this weekend before we travel
back to Dallas and I get ready to go to the annual economics fishing trip
(informally called Camp Kotok after David Kotok of Cumberland Advisors, who
organizes the event). It is one of the highlights of my year. I get to see lots
of friends and talk economics and meet interesting new people. I try not to let
the fishing get in the way of having a good time.
At the end of the month Shane and I will head to Beaver Creek,
Colorado, for a few days in the cool mountains, readying for a busy fall. Later
in September I will head to Lisbon after speaking in Wisconsin the day before I
fly. Otherwise, I’m trying to stay home as much as possible so that I can work
on my writing and research, but this week I spent two full days simply working
through my monstrous email backlog. It is amazing how fast emails can pile up
in my inbox.
Next week will mark the beginning of the 18th year that
I’ve been writing Thoughts
from the Frontline. All my good calls and great calls and all my
bad and truly annoying calls are archived for everyone to see. I admit it’s
tempting to delete a few of those letters from the archive, but that would not
preserve the level of authenticity that I want to keep. I’ll write more about
that anniversary next week, but for now let me thank you for being with me. As
one friend and reader said to me a few days ago, “Yea, though I walk through
the Valley of the Shadow of Death, I will fear no central banker, because John
is there beside me.”
It’s time to hit the send button. You have a great week, and I’ll
be writing to you next week from Maine.
Your glad we’re all in this together analyst,
John Mauldin
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