The US Yield Curve Flipped Back to Normal, Is the Recession Off?
A lot of attention was paid this past week by the financial media to the inversion of the yield curve. To understand the signal, it is important to define the circumstances. The yield curve is a comparison of the yield – in this case, on US Treasuries – of different durations. Normally, the longer the duration, the higher the yield should be owing to the longer tie-up of exposure. When a curve inverts, we have an atypical circumstance where there are lower yields (and thereby it is construed lower risk) to hold US government debt of a longer maturity than that of a shorter variety. That is unusual but not at all unheard of. When looking at two proximate maturities – such as 2-year and 3-year debt – brief, technical inversions can occur owing to issues like liquidity. Yet, what we saw last week tapped into the extremes: the 10-year / 3-month yield curve inversion. These are the most extreme of the top liquidity issues and thereby a favorite measure of economists to gauge economic potential. In fact, this specific spread is one of the economists’ favorite recession measures. So you can understand the wave of concern, and media interest, when the 3-month yield overtook its much longer termed counterpart. However, I was (am) skeptical that this signal is as useful as it has been in the past. Thanks to the Fed’s adoption of quantitative easing so many years ago, we have seen a serious distortion in monetary policy that comes to the forefront with their effort to normalize – starting with rate hike before addressing the unorthodox policy outlook. Given my skepticism of the signal’s efficacy with the inversion, I am equally as indifferent to the fact that the curve flipped back to positive this past Friday. There are some interesting considerations from this yield comparison, but they shouldn’t be taken at face value as they have in the past.
So, where to from here with this traditional economic measure? I am of the opinion that the yield curve has been distorted and its ability to reflect economic pacing has been seriously undermined. However, the interest should not be in the tool that measures sentiment but rather sentiment itself. While I am dubious of what the 10-year / 3-month yield curve represents, its inversion just so happened to coincide with other more convincing indications that the economy is at risk of capsizing. Measures of economic activity virtually the world over have signaled a throttling while readings considered forecast (such as sentiment readings) continue their own slide. Add to that a speculative market that recognizes the unquestioned safety net of the past through central bank commitment will no longer support the kind of speculative excess we are dealing with, and we find traders are more cognizant of their personal exposure. Where few risk benchmarks are as excessive as the favored US indices, there is still a remarkable amount of speculative appetite / complacency built into most sentiment-dependent measures. As the realities of the economy and practical rate of return deepen, the systemic appetite for ‘risk’ exposure will continue to struggle. In short, recognize that the market is increasingly attentive to troubles on the horizon rather than the ‘troubled’ or ‘return to normal’ signals that we register from some of these traditional measures.
The Start of a New Quarter and Greater Scrutiny Over Sentiment
Depending on how you evaluate this past week, you could be left with a dramatically different opinion of market intent moving forward than some of your market peers. With this past Friday’s close, we have not only capped the trading week; but it was also the end of the month (March) and the first quarter. If we look at performance via the largest of those time frames, the recent past was extraordinary. Both the S&P 500 and crude oil posted their biggest quarterly rallies in a decade – 13 and 31 percent gains respectively – which is fantastic for diehard bulls that had grown nervous in 2018. That said, this performance was far from uniform across all assets with a sentiment bearing. Global indices regained much less of their lost ground compared to their US counterparts, while both more overt risk assets and growth-dependent benchmarks were seriously struggling. What’s more, the impressive rally follows a period of even more intense loss for these assets. The fourth quarter of 2018 suffered the kind of loss that we can only compare to the Great Financial Crisis. Mounting a recovery from such a severe retreat naturally insinuates a certain degree of pacing. Yet, it does not automatically imply intent. If we put these past two quarters into further context of the previous year, regular bouts of volatility and focus on fundamental maladies speaks to a lost momentum to self-sustaining speculative inflow. A rebound, in other words, is easier to accomplish. Fostering new sense of enthusiasm and a fresh wave of investment is a different beast entirely. That is not what we have registered recently.
As we move into the second quarter of 2019, we continue to face a number of systemic fundamental threats: trade wars, fears of monetary policy limitations, fading growth forecasts, and more. If indeed the temporary discount from emergent, manufactured threats (like trade wars) has already been tapped; fostering further gains will prove very difficult as the global economy struggles and central banks are forced back into the role of protector. A contrast in market performance will be even more critical to keep tabs on. The performance of US equities relative to their global counterparts is one point of clear division that makes clear confidence is not global. Emerging market assets underperformance speaks not only to the lack of return the markets expect from this high-risk assets, but also the concern that global central banks are unable to close the gap. In particular this quarter, my interests will be the relative health of those assets that are more explicitly speculative in patronage compared to those with deeper ties to the genuine health of an economy. Commodities are just such an asset type that finds itself in the latter category. If GDP is throttled, demand for these goods flags which is an inherent weight on prices. Perhaps the most interesting market to keep tabs on for the overall health of the financial system is government bond yields. Historically, yields on these products are positively correlated to risk benchmarks like equities as capital moves away from their haven appeal thereby raising the return necessary to draw interest. Yet, we have to add to this the economic implications that are starting to garner greater interest as well as the central banks’ distorting influence through stimulus – a dubious structural support. If government yields continue to tumble as stocks rise, it is much more likely that equities are the market that capitulations to close the divergence.
Brexit, Now What?
Like a chess board cleared of all but a few pieces that are constantly moved to avoid a conclusion, the outcome for Brexit has been officially delayed (again) and the remaining possible outcomes is dwindling to fewer – and in most cases, more extreme – options. This past Friday, March 29th, was the original Article 50 conclusion date. Before this milestone was hit, Parliament attempted to wrest control over the directionless ship with a series of indicative votes that put to tally solutions that MPs believed could overcome the lack of support for Prime Minister May’s repeatedly rejected plan. All eight of the proposals failed to hit the critical market necessary to signal clear support. Empowered by this outcome and perhaps imagining strategic advantage in growing concern of a ‘no deal’ outcome, May put her scheme to vote once again on Friday. The third time was not the charm as 344 rejected her effort against 286 that supported it. After the outcome, the European Commission’s Donald Tusk called for a council meeting for April 10th while the EU stated, for both dramatic and practical effect, that a ‘no deal’ outcome is now a likely result. As a reassurance to local citizens and businesses, European officials said that they were prepared for such an outcome. Underlining this pledge is a not-so-subtle ding against the United Kingdom, insinuating that they, in turn, are not prepared for course they don’t seem to be able to navigate away from.
The next critical date on paper for the divorce proceedings is Friday April 12th. That is the time frame that was given for the UK to find a deal or ask for an extension. It was previously offered by EU officials that if May’s withdrawal agreement – agreed between both sides late last year – then they could offer time out to May 22nd, just before the EU elections to work out the details. On the docket over the coming week, we have specifically penciled in another House of Commons run of indicative votes with MPs making the same assumption that May did that support will be mustered behind recognition that time is frighteningly short and the solutions extraordinarily few. These votes are non-binding and the mood of the crowd doesn’t seem to have shifted materially. Instead, what progress we do find on Brexit this week is likely to originate from unexpected headlines. A change in support from the DUP, surprise concessions from the EU, allowance for a ‘people’s vote’; while these may seem low probability, they are as fair to consider as an ‘accidental’ no deal would be. Don’t be surprised to see either some unexpected shift in the landscape or the plug to be pulled altogether. Anticipation and fear will keep liquidity in the Pound tempered and thereby volatility high. That makes for very difficult to trading, so don’t let the flash of sudden movement lure you in like a fish to hook. That said, it is worth noting that one of my top trades for 2019 was – and remains – a long Pound view when we clear on the outcome of the divorce. If it is a deal, the earnest recovery will begin soon after confirmation is delivered. If it is a no-deal, the rebound will take longer as the market acts to work out its exposure.