Up, down, all around

Up, down, all around.  Markets were very choppy yesterday principally driven by news on the China trade front and news from the Oval Office (if you could call it that).  Markets started the day digesting positive news that China would resume soy bean purchases and were considering removing tariffs on automobiles.  The positive news was met with a rally in equities despite a PPI number that showed prices paid by producers grew at a greater than expected pace.  The rally slowly faded and hit a low point after a televised and highly contentious meeting between President Trump and democratic congressional leaders during which the President said he would be “proud to shut down the government” if he didn’t get full funding for the proposed border wall.  The meeting was such a spectacle that traders were initially unsure how to react.  It was initially met with selling, then ultimately buying, rocketing indexes into the green, and then… selling again.  It should be clear by now that the trade issues related to China are on the top of traders’ minds.  Unfortunately much of the news represents no real tangible progress leaving it up to traders to interpret and speculate about the eventual result.  Ultimately stocks ended the day mixed with the S&P 500 closing off -0.04%, the Dow Jones industrial Average closing down -0.22%, the Russel 2000 slipping by -0.21%, and the NASDAQ 100 gaining +0.32%.  All of the major indexes remain risk off with the Vix index around 21.25 indicating continued volatility.  Bonds, as is typical, took a more practical  approach to yesterday’s news stream ending the day virtually unchanged as ten year yields traded up around 3 basis points.  Bond traders remain focused on the Federal Reserve with just a week to go before the FOMC meeting.  The Fed is still largely expected to raise rates by 25 basis points with a probability of 76%.  Interestingly at this point there are even odds between one and no rate hikes next year.  Bear in mind that just a few weeks ago the odds were in favor of 2 – 3 hikes for 2019.  These probabilities are based on Fed Funds futures which are dictated by the market, so traders are betting on no rate hikes next year.  This is the result of dovish speak from governors, the equity market downturn, and the emergence of an increasing awareness that the economy will slow down starting next year.  This feeling is further evidenced by the shape of the treasury yield curve, which came close to inverting last week.  In fact, the front end of the curve did invert between 3 and 5 year maturities causing a big stir.  Because it is geek-out Wednesday, I thought I would talk a bit about yield curve inversions.

First, a quick refresher about the yield curve itself.  The yield curve plots yields of various maturities, typically 2 years through 30 years.  The breakpoints are based on the set maturities by the US Treasury and include 2, 3, 5, 6, and 10 year notes as well as the 30 year bond (some plots include 3, 6, 12 month bills).  The yield to maturity represents the rate that the US Government must pay bond holders to borrow money.  Treasury notes and bonds pay semi annually coupon payments and return the face value principal at maturity.  Bondholders are lending the government money for the life of the bond and, as would be expected, longer maturities would warrant greater returns due to the greater risk based on the uncertainty of the future health of the economy.  Imagine lending your money and locking in a yield based on what the economy might look like in 30 years!  More specifically, lenders would be sensitive to inflation because of the fact that treasury coupons are set at the time of issue, so if inflation goes up during the term of the note, the lender will earn a lower real return making the bond less valuable.  If you recall, a bond’s yield to maturity is determined by the maturity, coupon, and current market price of the bond (for more detail, refer back to my September 19 geek-out Wednesday note).  If bond holders believe that inflation is going to go up, they will demand higher yield to maturity, which would in turn cause bonds to go down.  Please also recall that bondholders get back face value at maturity.  In the case of treasuries, you would get back $1000 at maturity.  So if you paid less than par (100) for the bond, say 90, you would have paid $900 for the bond and you get back $1000 at maturity in addition to the twice a year coupons thus making your yield to maturity greater than the locked in coupon.

Now back to the Fed.  Remember that the Federal Reserve manipulates short term rates to combat near term inflation moving them up to apply the brakes, and bringing them down to press on the accelerator.  The key to that statement is “short term”, indicating that the front end of the yield curve is under their control.  The back end of the yield curve is controlled by supply and demand, AKA speculation about future inflation.  Got it?  To be clear, inflation by itself is not a bad thing but rather, it is healthy.  Inflation means that your wages should be going up over time and the prices of goods are going up as well (great if you are selling those goods, not so great if you are buying them).  The problems start when inflation gets too high to fast which causes discrepancies and disconnects that make goods unaffordable causing economies to collapse.  So in a normal environment where traders believe that inflation is under control (the Fed thinks that 2% is good) and expect the economy to be stable, the yield curve has a positive slope.  If traders believe that an economy will experience deflation, longer term yields will go down causing the yield curve to flatten, ceteris paribus.  Ceteris paribus is a fancy economics term that means: all other things remaining constant.  I used the term to indicate that if the Fed is holding short maturity rates steady and long rates are decreasing, the yield curve will flatten.  Imagine if the Fed is raising rates and traders believe that there will be deflation in the future?  You guessed it… inversion!  Economies are cyclical experiencing periods of growth through expansions and pull backs through recessions.  During an expansion phase prices experience natural and healthy inflation and when inflation begins to pick up to the point of being unhealthy, the Federal Reserve intervenes and begins to methodically raise short term rates.  The rate hikes can go on for some time before any real results are felt by the economy and during that period the treasury yield curve may flatten a bit but will still have a healthy positive slope.  At some point in every cycle the rate hikes begin to slow the economy down, which historically end in a recession and deflation.  When traders believe that the tipping point is approaching they will buy longer maturity treasuries pushing down long yields while the Fed is simultaneously raising short maturity yields.  That is why the yield curve inverts before recessions!!  The inversions don’t last long because once a recession is imminent, the Fed begins to lower rates, which causes the yield curve to take on a positive slope once again and a new cycle begins.  This is precisely why traders are so worried that the yield curve will invert and, of course, the fact that historically, the curve will invert prior to recessions making the event a strong statistical indicator.  To get a graphical understanding of this, take a look at the attached chart of the historical yield curve.  You will note that the graph depicts the spread between 2 and 10 year maturities and that the spread became negative prior to each of the last 5 recessions starting in 1980 (recessions are the grey boxes).  I think we can all agree that there will be a recession in the future, the big question is when.  Unfortunately an inversion only implies: soon, which is not a number.  It can also invert multiple times before the recession occurs, so if the curve inverts it may not spell immediate doom.  In conclusion, normal, positively sloping yield curves occur when investors believe that inflation will be higher in the future.  If the Fed is raising rates to slow inflation the curve will flatten.  If investors believe that future inflation will be lower or deflating the yield curve will flatten aggressively and ultimately invert.  The curve returns to its normal shape once the Fed starts lowering rates once again.  As with absolutely everything in economics there are many differing opinions, which is why its is said that 2 economists have 3 opinions.  These differing opinions have hit a  high point recently, which is precisely why markets have been so volatile.

This morning we received the Consumer Price Index and it came in right on expectations with core CPI growth at +2.2% year over year versus last month’s reading of 2.5%.  This can be interpreted that inflation is under control.  This should provide a positive signal to equity markets which are already in a positive state of mind.  Today’s positivity comes from overnight progress in trade talks with China.  Huawei’s CFO has been let out on bail and the Chinese appear to be open to increase foreign investment opportunities in China.  Today will be a another day of debating trade with a sprinkling of Brexit and yesterday’s Oval Office cat fight.  Please call if you have any questions.

daily chartbook 2018-12-12

yield curve history