Interest rates have been the primary focus of investors lately, and for good reason. A glance at the chart of the 10-year Treasury note yield below shows that while rates have been steadily declining for nearly a year, that move accelerated sharply during the last two weeks.
Remarkably, in just under ten months the bellwether 10-year note’s yield has fallen in half, from a high above 3.2% to a low of 1.6%. Those who recognize the power of messages emanating from the bond market understand intuitively that something is off. But what, exactly, is that “something?”
There are two possible explanations here. The first is that this is a symptom of weakening economic fundamentals. In a past note, we looked at research from Aswath Damodaran, Professor of Finance at NYU, that demonstrates how long-term rates are really just a function of expected inflation and real GDP growth. When those two variables move lower, so do the yields on longer-dated bonds.
This makes perfect sense, and that relationship has held up well over the past 65 years. However, what’s unique about our current environment, and the other plausible explanation for what’s going on, is the massive amount of foreign sovereign debt that now trades with negative interest rates.
Right now, nearly a quarter of all government debt around the world has a negative yield. Said differently, approximately $15 trillion worth of global debt now involves investors paying governments to babysit their money.
Why would someone do this? Well, if we assume that investors generally act rational (we know that they certainly don’t always act rationally), it’s simply because that’s the best alternative they can find. Might as well lock in a small guaranteed loss as opposed to taking on the risk of a much larger potential loss.
So the real question facing investors right now is whether this latest drop in yields is a harbinger of recession (representing vastly deteriorating levels of inflation and economic growth), or whether it’s simply a byproduct of vast amounts of money flowing into U.S. Treasuries from around the world, in search of a safe yield that is greater than zero.
Let’s examine some of the evidence in support of both ideas. First, if our yields are being suppressed by large swaths of money flowing into the U.S. for safe haven purposes, then we would expect to see both a strong dollar, and bullish price action in gold. As you can see in the two charts below, this is exactly what’s happening.
The top panel above shows the dollar in a sustained uptrend (suggesting strong demand for dollars to buy Treasuries and other dollar-denominated assets), while the lower chart shows a surge in the price of gold. This latter move is indicative of a search for safe haven assets in general. Typically, gold and the dollar would move in opposite directions, but in this environment both have something to offer.
Therefore, it’s very plausible, in my opinion, that negative yields elsewhere are having a major gravitational pull on Treasury yields here. Big surprise, right?
Now let’s take a moment to consider the other alternative – that this latest drop in long-term yields reflects a sharply deteriorating economic outlook for the U.S.
This one’s a bit harder to piece together, and frankly is made extremely noisy by the fact that our president and the USTR keep flip-flopping on trade. Just today, Trump’s recent tweet about 10% tariffs on the remainder of Chinese imports went out the window, as the USTR said that it would delay and remove some items from the roughly $300 billion of imports facing tariffs on Sept 1.
This level of uncertainty not only causes big fluctuations in the market, it leaves companies sitting on their hands in terms of laying a foundation for future growth. With uncertainty like this, you can bet the focus of every management team out there is on protecting current earnings, not driving growth or investing for the future. In other words, companies right now are playing defense, not offense.
And they’re having a tough time. With 90% of S&P 500 companies having reported, blended earnings growth for the 2nd quarter sits at -0.7% (FactSet). Recall that earnings growth in the first quarter was also slightly negative.
But surprisingly, outside of corporate profits, U.S. economic data remains lackluster but is holding up okay. The National Bureau of Economic Research (the official arbiter of recessions) typically looks at four coincident economic data points when assessing the beginning and end of a recession: payrolls, personal income, industrial production, and manufacturing/trade sales. Here’s a look at those four metrics.
Net payroll gains have slowed during 2019, but our economy continues to add jobs at a faster rate than what’s needed to maintain full employment.
Personal income is up 4.9% from year-ago levels (up 3.5% in real terms), with growth accelerating slightly.
Industrial production has slowed over the past year but growth remains positive – currently up 1.3% from year-ago levels.
And manufacturing and trade sales are up 1.6% in real terms, which is closer to 3% nominal growth.
So as you can see, we have a bit of a mixed bag. The economy continues to expand, but the rate of growth is slowing. The Conference Board aggregates each of these four components into their Coincident Economic Index, and that particular index rose 0.1% in June, following a 0.2% increase in May and no change in April. Thus, the message is similar – slow growth, but growth nonetheless.
Also, we received the latest CPI data today (for July) and it actually showed an increase in year-over-year inflation. As you can see below, both headline and core inflation ticked higher, with headline inflation now at 1.8% and core inflation at 2.2% (above the Fed’s target).
We know that the Fed prefers to look at Personal Consumption Expenditures (PCE) as a its price gauge for setting monetary policy, but in theory the two indexes should and generally do move in sync with one another.
So while we do have a tough and slowing global environment, and growth is absolutely being held in check by the trade war and strong dollar, it does not appear (to me at least) that the economy is in as steep of a downtrend as evidenced by longer-term bond yields.
Now that we’re back on the topic of bond yields, I want to point out that regardless of what’s causing bond yields to fall, this development is really screwing with the minds of investors. As we all know, the yield curve is one of the best recession predictors available, and many recession probability models are created using various spreads.
The chart below comes from the New York Fed, and shows recession probabilities based on the slope of the yield curve (3-month minus 10-year). As you can see, the probability of a recession one year out now stands at roughly one third.
In a previous article, I also introduced findings from two Fed researchers (Eric Engstrom and Steve Sharpe) demonstrating that the use of a near-term forward spread may have a higher statistical accuracy in terms of forecasting recessions than some of the longer-dated term spreads.
Recently, Liz Ann Sonders, over at Charles Schwab, reproduced a chart originally created by Dave Rosenberg and the folks at Gluskin Sheff Research, that took the data from the Engstrom and Sharpe research and constructed a recession probability model. The results of this model are shown below, and while it doesn’t have as long a history as longer-dated terms spreads, you can see that it suggests the probability of recession is very high (above 80%). Making matters worse, every time this particular model has spiked above 80, a recession has indeed occurred.
What’s particularly unique about this model, as opposed to the longer-term yield spreads such as the 3-month minus the 10-year shown in the 2nd chart above, is that it doesn’t use long-term interest rates. This removes the influence of the massive drop in the 10-year note that may or may not be the result of global bond yield suppression.
Instead, this model is a reflection of the market’s expectations for the direction of near-term conventional monetary policy. In other words, the more the market expects the Fed to ease in coming months, the greater the chance of an approaching recession.
So the main takeaway here is that even without factoring in the big drop in the 10-year note yield, market participants do see recession risks as elevated and rising. The only thing I would add is that I believe the market is overly aggressive in terms of anticipating easier monetary policy, which would show up in this chart as an elevated probability of recession.
Before we wrap things up, I want to point out some positive developments to help assuage your fears. First, this chart (courtesy of Charles Schwab) shows the state of fiscal policy leading up to recessions.
Notice that prior to the last seven recessions, fiscal policy was tightening (yellow arrows). However, thanks to the tax cuts and other spending measures, we’re already in a fiscal stimulus type of environment, with the deficit rising.
Therefore, we’re effectively seeing both fiscal and monetary stimulus being added to the economy; fiscal in the form of additional spending, and monetary in the form of lower short-rates, but more importantly, lower long-term rates (see last week’s article for more on that).
Moving on, we also have not seen a big selloff in the high-yield (aka. junk bond) market. Notice in the chart below that high yield bond prices remain just off their all-time highs.
Finally, while the market has been extremely volatile lately, the NYSE Advance-Decline line (top panel below) is holding up just fine. For those wondering if perhaps this metric is being bolstered by bond related issues, the common-stock only A-D line is included in the lower panel, and that has also yet to break below prior lows.
Alright, so with all of these crosscurrents in motion, what do we do from an investment perspective?
Right now I believe conditions warrant holding on to your core positions in equities, and possibly looking to add to those positions on weakness. In the face of extreme uncertainty, equities are still holding up well and bonds are now priced through the roof. This is pushing us back into a TINA (There is No Alternative) environment.
We also have both fiscal and monetary stimulus that is working its way through the system, will probably get more monetary stimulus in the from of additional rate cuts from the Fed, and as we saw last week, have some encouraging early shoots in global composite PMI data.
The dollar also remains very strong, and in theory should weaken if the economy deteriorates further. That would help to stimulate economic activity, thereby acting as something of an automatic stabilizer.
Overall, it seems to me that while the wall of worry is very large and looming, the U.S. remains the best house on the block, and stocks currently offer a better risk/reward picture than bonds. That could change if conditions deteriorate further, but right now I think the jury is still out on whether a recession is imminent.