Guiding You Through Uncharted Waters
Issue 14/19 for April 5, 2019
A LOOK BACK AT A SIMILAR YIELD CURVE INVERSION
Last week’s Investment Update talked about how important interest rates are for the markets and the economy. In normal times, interest rates on a short-term GIC or mortgage are approximately 2% lower than rates on a 5-year GIC or a 10-year government bond. However, at certain times when the economy is too strong and rising inflation becomes a concern, authorities at the Bank of Canada, the European Central Bank or the U.S. Federal Reserve Board (the Fed) raise interest rates in order to try to restrain economic growth. Authorities at the central banks can only raise short-term interest rates. (The rates for interest paying investments with maturities longer than 3 months or so are decided by market forces.) When a central bank raises interest rates so much that the rate on a 3-month Treasury Bill is higher than the yield on a 10-year bond, the normal interest rate relationship is upside down or inverted. Please see the example below.
In 1996, two Federal Reserve Board economists looked at 26 different statistics and determined that the inverted yield curve (using the 3 month U.S. T-Bill and the 10-year U.S. government bond) is the simplest and most reliable
indicator of a recession in the Unites States in the next 6 to 18 months. There are numerous economic statistics which makes it seem as though understanding what is happening in the economy is so complicated that it takes an expert to figure it all out. The simplicity and significant impact of the inverted yield curve shows that is not the case. If we distill all the negative factors down to what really matters, the inverted yield curve is one of the two major negative factors. A
recession puts businesses to the test. More businesses fail during a recession than during any other time. This is one reason why stock prices decline close to 85% of the time when there is an economic recession in the U.S. Therefore, when the U.S. yield curve inverted for the first time since 2006 on March 22, 2019, it made the headlines and caught everyone’s attention, and rightly so. It seems like one half of the investment community focused on the fact that the yield curve inverted and the other half wrote about how everyone else was giving the inverted yield curve too much attention.
The 0 line on the chart below indicates when short-term rates were higher than long-term interest rates since 1982. The shaded areas show when there was a U.S. recession. If you examine what has happened in the past, I believe the inverted yield curve deserves all the attention it can get. What do you think?
If you look at the section Observation in the top left hand corner, you will see that it says 0.08(+ more). This indicates that the yield on the 10-year bond is now a tiny fraction (0.08%) above the 3-month T Bill. The same chart a week ago
showed the spread was -0.05% below the 3 month T Bill. The yield curve was just barely inverted for a week. Now it is positive by a very small margin. Last week’s Update stated that the yield curve needed to remain inverted for a month or so to give a credible recession warning. Given that there seem to be some mixed signals over the last two weeks, what might this mean?
Winston Churchill said, “The farther you look back, the farther ahead you can see.” A wise U.S. judge, Oliver Wendell Holmes wrote, “A page of history is worth a volume of logic.” Therefore, rather than providing a volume of what is
happening in the global economy right now, lets look back at what has happened in the past to see if it can provide some clarity at a time when this back and forth action seems to be confusing.
U.S. stock prices just experienced a 20% decline in late 2018 so it would be most unusual for another bear market to occur so soon. In addition, the behaviour of investors in the equity markets triggered a 2-1 Advance/Decline Buy Signal on January 9, 2019. This has always been followed by attractive returns for at least a year. This also suggests that the odds of a recession or bear market in the next 12 to 18 months is extremely low. When I looked back, I found there is another occasion when the circumstances were similar to today.
The U.S. economy and stock prices were strong during the first half of 1998. Many will remember that was the year 49-year old President Bill Clinton was implicated in a sex scandal with a female White House intern. While the impeachment process dominated the headlines that summer, there were some major market developments that rattled equity and bond markets in August and September of 1998.
Previous Updates have talked about 16-18 year cycles of commodity prices and equity markets. By 1998, commodity prices were in their 17th year of consolidation. Russia is a major commodity producer. Russia was so devastated
by the long period of depressed commodity prices that it defaulted on its government debt in August 1998. To make matters worse, a hedge fund that was managed by two Nobel Prize winning economists, (called Long Term Capital
Management with a massive $126 billion in assets in 1998) had made huge, leveraged purchases of Russian bonds since they were so cheap in their view. The Asian Crisis in late 1997 and the collapse of Russian bond prices resulted in
significant losses for Long Term Capital. The S&P 500 fell by 20% by the end of August as the Federal Reserve was forced to intervene in order to enable Long Term Capital to liquidate their investments in an orderly manner without
disrupting equity and bond markets.
The quick 20% stock market decline in August 1998 and the turmoil created by Long Term Capital fanned worries that the U.S. economy would slow down, causing bond yields to drop and the yield curve to invert very slightly on a few
days during that period. The yield curve was inverted by .02% on September 11, 1998, by .12% on September 21, 1998, by .08% on September 22, 1998 and by .07% on October 7, 1998. The Fed intervened again on September 28, 1998 by lowering interest rates 0.25% and a new bull market in stocks began in early October 1998, continuing until 2000. Long Term Capital Management did not end up lasting as long as the Nobel Prize winners thought it would since it took another two years to sell all the assets and dissolve the fund in the year 2000. (That is what happens when one focuses only on the fundamentals of an asset and ignores momentum.)
The chart from the Federal Reserve Bank of St. Louis for 1998 below shows when the yield curve inverted those few days as mentioned above. However, if you look at the 27-year chart on page 3, it looks like the yield curve did not invert
at all. In this case, taking a closer inspection at the details is most useful.
By the final quarter of 2018, the Fed had increased interest rates by 0.25% nine times. In addition, the impact of rising prices of aluminum and steel together with concerns about trade with China were creating signs of slower growth in the U.S. and China. This reduced the confidence of business owners and investors in late 2018, just like the collapse of Long Term Capital Management reduced the confidence of market participants in 1998. Concerns about slower growth caused equity markets to fall by 20% in August 1998 and the last quarter of 2018. These concerns also caused yields on 10-year government bonds to fall in 1998 and 2018, causing the yield curve to invert by a tiny fraction for only several days.
In 1998, the Fed came to the rescue and intervened by organizing and orderly liquidation of Long Term Capital and then by lowering interest rates in September.
In the last quarter of 2018, the Fed was a major part of the problem when Powell and the other Fed officials ignored the decline in stock prices and the collapse in crude oil prices by increasing interest rates by another 0.25% on
December 19, 2018. At the time, Powell said the Fed would hike interest rates two more times in 2019 as well.
We must always remember that confidence is the cornerstone that the global economy and markets rest on. Confidence is impacted not so much by economic statistics but by how people feel about prospects for the future. In late Powell
made a major policy mistake by focusing on economic statistics instead of what was happening in the bond, equity and oil markets. Economic statistics are usually several months old so they do not reflect what is happening at the present time. Commodity, equity and bond markets reflect the level of confidence today, not a week ago or a month ago. The Fed should not respond to every gyration in markets, but when the movements become major as they did in 1998 and 2018, the Fed needs to take note. Powell took note too late in 2018. He realized his mistake and was at pains to reveal that the Fed had taken a 180-degree turn at a news conference on January 4, 2019. This restored confidence to the markets just like the Fed’s action under Alan Greenspan restored confidence in 1998. At the Fed’s latest meeting last month, Powell stated that the two interest rate increases planned for 2019 are now off the table. The markets were telling him there should be no more interest rate increases in December 2018, but Powell is only seeing the economic statistics to support that three months later. Long Term Capital Management was operated by Nobel Prize winners in economics. The Federal Reserve has some of the most educated and experienced economists on its board. However, this does not mean that they are immune to making mistakes and errors in judgments.
Warren Buffett was talking about what institutes of higher learning are teaching to market analysts and economists when he said, “You could not advance in finance department in this country unless you taught the world was flat.” He is
saying what men and women are being taught is out of touch with reality. The actions of Long Term Capital Management in 1998 and the actions of the Fed in December 2018 came about because the people in charge were out of touch with reality. Hopefully Powell is learning from his experience. Major trends in markets are one of the best and most current barometers of confidence and economic growth. Anyone who ignores major market trends is missing important up to date indicators for the economy.
What happened after the yield curve inverted for a few days in 1998? The chart on page 3 shows there was no economic recession until after the yield curve inverted for several months two years later in July 2000.
The chart of the S&P 500 below from Thomson Reuters shows how investors reacted after the yield curve narrowly inverted for a few days in the fall of 1998. The green arrow shows when the bear market ended two weeks after interest rates were reduced by 0.25%. Within a space of three months, the S&P 500 had risen to an all-time record high by the end of 1998. The S&P 500 rose 56% in the following two years.
In conclusion, if the yield curve is only inverted for a very-short period of time due to a quick bear market, history suggests that a recession could be averted and equity markets can resume their long-term uptrend. I will keep you informed about movements in the yield curve in the weeks ahead.
The Fraser Valley has had an incredible winter with a warm January, a cold February and then a sudden shift to almost summer weather in March. It has been dryer than normal too. This becomes very obvious when you go to a place like
Harrison Lake where this boat and personal watercraft rental dock that is usually floating all year every year is high and dry. Locals say the water has not been this low for at least 40 years. I am sure it water levels will recover soon. Make it a great weekend!
Dave Harder, CIM, FCSI
Vice President and Portfolio Manager
RBC Dominion Securities
604-870-7126
Toll Free 1-866-928-4745
dave.harder@rbc.com
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