Research.LeutholdGroup

There has been chatter about the Fed implementing the so-called Yield Curve Control (YCC). Although the latest FOMC minutes suggest that YCC is not on the agenda for now, we believe the chance of YCC is probably much higher than the market currently anticipates.

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As the coronavirus materially increases the odds of a recession, some important parts of the U.S. yield curve (10Y-3M; 5Y-2Y) double-dipped into inversion. The two prior episodes occurred in late 1989 and mid-2006 and, in both cases, a recession followed within 18 months.

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We can’t count the number of times in the last week we’ve heard analysts worry about “what the Fed might know that we don’t.” In the words of John McEnroe, “You cannot be serious!”

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A way to gain perspective on the present is by trying to view it from the future. Ask yourself, “What are the signs of impending decline, now ignored by investors, that will one day be memorialized by the same investors as the most obvious in retrospect?”   

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This year’s upswing in money-supply growth has been one of many factors that’s prevented our economic work from triggering a recession warning. Following a two-year decline, year-over-year growth in M2 bottomed near 3% late in 2018 and has trended upward all year, reaching 6.7% in the latest week (Chart 1).

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The U.S. yield curve inversion has lasted long enough that even a few economic optimists now concede it will ultimately prove significant.

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The yield curve’s ten-month moving average inverted in September, hence the yield curve inversion can no longer be dismissed as transitory; the Boom/Bust Indicator remains below its descending 10-month moving average, confirming economic weakness predicted by the yield curve; and, the “Present Situation” component of September’s Consumer Confidence survey slipped below its 10-month moving average for the third time in 2019.

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We always do our own work and draw our own conclusions. Lately, though, we’ve wondered what the late “Monetary Marty” Zweig might say about the stock market’s current liquidity backdrop.

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Over a 12-month horizon, we now believe a U.S. recession is very likely, but aren’t confident enough to make the call when the forecast window is cut in half. Second-half stock returns could be decent if the business-cycle peak is still a year away. Then again, there’s peril in waiting for “too much” confirmation of recession.

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While the 10Y-3M curve inversion does warrant extra attention, movements in other parts of the curve also need to be taken into consideration.

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Last month, we observed that crude oil was the only item propping up broad-based commodity indexes, and that something was bound to give with the U.S. dollar pushing to new highs.

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Signs of spring are popping up everywhere in the Financials sector. S&P Financials was easily the top- performing sector in April and several sub-industries have been bubbling higher in our Group Selection discipline.

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Some recent headlines are word-for-word regurgitations of those published in response to the early-2006 yield curve inversion. In that case, the naysayers were temporarily correct, as both the U.S. economy and stock market pushed higher for another year and a half before rolling over.

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While the celebration over Jerome Powell’s “Christmas Capitulation” lingered throughout February, we’re still awaiting signs the capitulation consisted of anything more than words.

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While the number of recession forecasts is on the rise, there’s a general reluctance among economists to project a downturn in the absence of a yield curve inversion.

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The December employment report temporarily eased fears of a severe U.S. slowdown. That’s a mystery to us.

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We’ve sometimes called the yield curve our “favorite economist,” so we were amused when some enthusiastic data miner in the Treasury market tried to slip us a cheap imitation in late November.

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It’s been amusing to watch the narrative surrounding Fed policy evolve as the market has rallied.

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The increasingly greater attention given to the yield curve by equity investors has prompted us to come up with an equity basket that can track the movement of the yield curve. Overall, it does a reasonably good job of capturing the major moves.

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How do today’s cyclical conditions stack up with those accompanying other stock market declines? 

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The gap between the 10-year Treasury yield and the federal funds rate has narrowed sharply in the last year but remains a long way (~110 basis points) from inverting.

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Bond market volatility picked up quite a bit in May but the higher-low/higher-high pattern in the 10-year yield is still intact, indicating the primary uptrend has not reversed.

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The U.S. 10-year ended the month 15 bps higher but non-U.S. bonds fared much better with bond yields in Europe and Japan 4-5 bps lower.

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The calm appearance of the 10-year yield masked a big curve-flattening move that has accelerated the last few months.

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The stock market is often maligned as a poor economic forecaster, and it’s true the market has predicted several more recessions than have actually occurred.

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Despite the late reversal in rates and the yield curve, the flattening trend of the yield curve remains intact. The fact that longer-term bond yields have fallen while the Fed is raising rates brings back memories of the “bond conundrum” episode during 2004-2006.

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The U.S. yield curve has flattened in the last few months but remains a long way from inversion—an event that’s preceded each of the last eleven recessions.

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Our current view is the lift-off will be December or later. Assuming inflation will pick up and the Fed hikes the rate by the end of 2015, stocks will perform relatively well, with international stocks a better bet than U.S. stocks.

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The steepening move in the yield curve is prevalent across many countries and is primarily driven by higher inflation expectations.

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With the Fed policy approaching actual tightening, the market is trying to price in a rate hike in the next year or so. This is a rather typical market response.

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The short end of the yield curve sold-off to price in an earlier-than-expected rate hike, while the long end rallied as the prospect of tightening reduced longer-term inflation expectations.

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We measure the sensitivity of common stocks to changes in interest rates using Implied Equity Duration. Growth-oriented sectors tend to have higher duration than Value-oriented sectors, while regional differences are largely explained by interest rate and risk premium differentials.

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The global yield curve is in a sideways range bound pattern, indicating anemic demand for credit. An examination of developed and emerging countries confirms our “muddle through” view.

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A Risk Contagion is now underway, and we continue to stay defensive and favor higher quality assets within the fixed income space. A silver lining: When the Risk Aversion Index moves above 1, odds start to favor a decrease in risk aversion going forward. The bulk of the move is probably done.

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Doug Ramsey examines several once very reliable relationships between stocks, bonds, inflation, and commodities.

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Recession risks don’t disappear the day the yield curve rights itself....the “window of vulnerability” extends for quite some time.

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The yield curve has moved away from inverted status, leading many to conclude the possibility of recession has been avoided. However, a look at past recessions reveals that a reversal of an inversion typically occurs prior to the economic decline– ranging from 6 months to over a year in advance.

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Doug Ramsey steps in as guest commentator in this month’s “View From The North Country” to highlight what we currently see as the bullish arguments for the stock market and contrast those with the bearish arguments.

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It may be difficult for the economy to prolong its expansion, with the auto and housing sectors weakening, and consumer spending a big question mark. 

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Continue to project higher interest rates over the next six months, particularly longer maturities. After rate hike in May, Fed’s actions will be more “data driven”.

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