Waiting for the Curve to Invert

Fri, Dec 15, 2017 - 2:37pm

One of the hallmarks of a bull market is climbing a “wall of worry.” Certainly, there is plenty of longer-term optimism with consumer and small business surveys showing extreme confidence. Yet, analysts seem increasingly focused on what might go wrong. In the early days of 2009–2012 most were certain that the trillions in money printing by central banks would cause massive inflation and thus contraction-level nose-bleed interest rates.

Recently, the worry du jour has been on rising short-term rates that are spiraling our yield curve towards inversion. It’s perhaps too widely known that yield curve inversion has always given an accurate warning of impending economic recession months later. In “waiting for the curve,” too many investors are cautious well before some unforeseeable inversion turning point.

This chart clearly shows that historically the “current” yield curve is not a concern and, in fact, will remain a positive factor as we approach inversion. Furthermore, even after the ominous flat yield spread is reached where short-term rates are equal to or above long-term yields, we often witness another year or more of positive growth before recessionary contraction pressures break the back of the expansion phase. Based on history, we have at least a couple years of expansion before push comes to shove in halting this 8+ year growth period.

We need to be cautious even about the merit of the yield curve if and when it does invert this time given the unusual influence of central banks adding reserves as never before. It should always be remembered that central bank efforts to flatten the yield curve, first in the US and later in Europe/Japan, are mostly an effort to regain some policy arrows to shoot back into the market in the form of lower rates and massive money printing at the first sign of any new economic contraction.

You can bet that central banks will be impatient to stop any recession before it starts (with 2 consecutive quarters of negative GDP). Note the sharper yield spread contraction during the 4th quarter (below), where 30-Year Treasuries ($TYX) fell, 10-Year Treasuries ($TNX) were flat and 5-Year Treasuries ($FVX) rose sharply. We suspect that long rates will start rising with shorter maturities in coming months as the Fed approaches its 2 to 2.5% Fed Funds target.

The NFIB Small Business Optimism index soared upon Trump’s election and has now soared even higher as the tax cut package becomes more certain in late 2017. Readers know we have been comparing the current period to various metrics from late 1995 and late 2004. Interestingly, even this Small Business sentiment chart shows a similar comparison of 2017 with 2004 when the economy really kicked into a higher gear. The current yield curve spread (1st chart) is near the April 2005 level when another 2 to 3 years of growth remained in stocks and the economy.

The US yield curve is aggressively flattening compared to the world as only our Fed has been pushing short-term rates higher relative to European banks in recent months. Europe and Japan will join the US and begin their tightening phase during the 2nd half of 2018. At some point in the first half of 2018, the market will anticipate this and trigger equity corrections and increasingly volatility skepticism prior to the next major run in stocks to new record highs.

It’s too early to be “waiting on the curve” to become defensive in stocks longer term. Correction odds will rise in 2018 after 13 months of record low volatility and only a few minuscule 3% hiccups. This may resemble 1996 conditions that ensued after its record low year of volatility in 1995. While 1996 had deeper corrections, it was still a very positive year of gains for stocks. It’s very likely the yield curve will be on the verge of inversion in about a year from now, but this is only a warning sign that will require a calm review of other metrics confirming that credit conditions are indeed very tight and warranted by an overheating economy. With this new post mortgage bubble era of aggressive central bank intervention, we are skeptical just how far a future credit contraction can last in this era of hyper-debt sensitivity.

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