“Dow falls 460 as US Recession Indicator Flashing Red” reads
a CNN Headline from last Friday.
Is it time to head for the exits? Are we tumbling into a
recession? The “bond vigilantes” are out in force waving the caution flags. But could there be another explanation?
What is the red flag? The yield on 3-month treasuries is now
higher than the yield on the 10 year treasury bond, a condition known as
“inverted yield curve”. The yield curve is a graph of interest rates on the
vertical axis and the length of time on the horizontal.
In the past and inverted yield curve has correctly predicted
9 of the last 5 recessions (to paraphrase Paul Samuelson). Or, as the Economist
Magazine put it last April: it is like going to a horror movie where the
floor boards are creaking, the wind whistles, doors suddenly open for no
reason. All scary stuff.
But like in the horror movie, the heroine and hero (that’s
you, the reader) always escapes.
Let me begin with the “bond vigilantes”. It has been decades
since I heard the phrase. It is not any specific group of individuals; the bond
vigilantes are bond traders. Back when I licensed as a stock broker in 1986, I
sat next to two bond brokers who had been in the business, one for 30 years,
the other for 15 or more. All they traded were bonds. They had lived through
the high inflation days of the 1970s and watched as bond prices cratered.
They told me that the best place to start, as a novice, was
to read The Municipal Bond Handbook by Feldstein, Fabrozzi and Pollack.
It is a two volume set of around 1,600 pages. And I did.
What I learned is that the total bond return is a function of the coupon or interest rate, the reinvestment rate of the interest earned, and capital appreciation. Each of those account for about 1/3 of the total return. Most financial advisors will build bond ladders which covers 2/3 of the total yield but they miss the last third. Bond traders make their money by understanding how to manage capital appreciation. 10% to 15% of The Municipal Bond Handbook is devoted to the interest rate and reinvestment of interest and the remaining 85% to 90% is devoted to that 1/3 which is the capital appreciation.
When interest rates are coming down, the capital
appreciation is easy to come by: Rates go down, prices go up. But when rates
are increasing, the work really begins for bond brokers and they become very
conscious of the yield curve and the quirks within it.
In November 2017 the yield curve flattened. On March 22,
2019 the curve became inverted.
There are three threats to the economy according to the bond
vigilantes. First, the Federal Reserve is tightening short term interest rates.
The Fed essentially has control of short term rates by setting the “Fed Funds
Rate” – the rate which banks loan other banks money overnight. During the Great
Recession, the Fed reduced that rate to zero and central banks in other nations
actually induced negative rates. Historically, the Fed and other central banks
raise rates to slow down the economy, to curb inflation. Slowing an economy can
cause a recession. That is the first concern.
The second concern is that the trade disputes are resulting
in bigger deficits and hurting profits for a number of companies. A significant
number of companies announced that tariffs will negatively impact profits.
The third concern is stock market volatility. When the
market is volatile, some traders sell stocks and buy bonds. They buy the longer
bonds.
As I said in the beginning, the inverted yield curve has
correctly predicted 9 of the last 5 recessions. If the yield curve inverts that
does not necessarily mean a recession will follow. On the other hand, if there
is a recession the yield curve will invert.
An inverted yield curve is not always a red flag. But it could
be. Consider the state of the world and who is buying treasuries. The Euro area
is entangled with Brexit. Theresa May has negotiated a bad Brexit deal (no
surprise – the UK did not have the leverage). If the UK does not get a deal
done, a no-deal Brexit is worse than a bad deal. It hurts the UK and also the
Continent.
Brazil, Russia, and any number of other countries are
struggling with their economies. While long term prospects are positive, the
shorter term it is looking very volatile.
And then there is China.
When there is turmoil in the world, central banks stock up
on US Treasury bonds – driving down prices. Additionally, Americans seem to
have a new passion for buying US Treasuries. It may be the latter that has been
the biggest driver of lower longer term bond prices while the Fed holds up the
short end. All of that is possible, but I do not think that this caused the
yield curve to invert.
In my opinion, what we saw on Friday was probably “Flight to
Quality”: Institutions selling stocks and buying bonds. Rumors have been
floating for several weeks the Mueller investigation was coming to a close. I
would guess institutions poking around heard of people closing their offices
and had a good idea the report was going to be released on Friday. Not knowing
what to expect, those institutions sold stocks and bought bonds in a move to
safeguard their equity. It is a classic move when there is the potential for
bad news.
The purchase of the bonds drove down prices of the 10 year
and caused the flat yield curve to invert. All in all, it is much to do about
nothing.
