Yield Curve is Now Pop-Culture?
“Hakuna Matata... it means no worries!”
- The Lion King
Our blog portfolio continues to perform well and volatility in the portfolio remains low vs the overall market. Year-To-Date the portfolio is up +18.45%. Our benchmark index, the S&P 500 is up 16.69% YTD.
The Yield Curve?
The yield-curve inversion has formally inserted itself into pop-culture, not because it tells us anything useful as investors, but maybe because its cool to talk about what's going to cause the next recession. We all love the salacious, fear mongering stories, they drive ratings and it all sounds so factual. Let me just say this, the yield-curve talk is all crap.
Every day I find new comments from seemingly knowledgeable, educated people. And this has been going on for a long while now because hardly anyone wants to believe that the US economy can keep expanding over 10+ years.
“This economy is going pretty well” Bill Maher said on his talk show. “I feel like the bottom has to fall out at some point. And by the way, I’m hoping for it. Because I think one way you get rid of Trump is a crashing economy. So please, bring on the recession. Sorry if that hurts people, but it’s either root for a recession or you lose your democracy.”
- Bill Maher
“Short-term pain might be better than long-term destruction of the Constitution”
- Richard Engle (NBC News foreign correspondent)
Below are headlines from The New York Times, just from July and August. Multiply this by all the other media outlets to get an idea of what the deluge of fear is doing to the average American who is thinking about how to invest and whether or not they should add more to their 401K at work.
July 28: “A Recession is Coming.”
Aug. 16: “Signs of Recession Worry Trump Ahead of 2020.”
Aug. 17: “How the Recession of 2020 Could Happen.”
Aug. 18: “In Economic Warning Signals, Trump Sees Signs of Conspiracy”
Aug. 19: “How a Recession Could Hit This Year.”
Aug 20: “Want to Prevent a Recession, Mr. Trump?”
Aug. 21: “CEOs Should Fear Recession.”
Aug. 22: “Trump Acclaims Economy, but Voters Are Anxious Amid Recession Talk.”
So why are celebrities in particular talking up recession worries? Let's remove the Democratic bias from Hollywood and just focus on the economics; politics usually don't enter into my investing thinking. A recent article in Variety points to the severe damage the film and TV industry suffered during the great recession (View Article Here). In 2008-2009 streaming services from Amazon, Facebook, Google, Netflix and others barely existed, so Hollywood suffered from a lack of discretionary spending and a complete erosion of advertising dollars. Today streaming services are the driving forces behind a significant shift in the film and TV industry. With Disney ready to launch its Disney+ streaming service, even Netflix is at risk of seeing its business deteriorate, let alone traditional film that relies on getting people off the couch and into a theater where the cost of a single ticket is more than the monthly cost of a streaming service.
In short, fear sells and it sells better when it comes from celebrities that we identify with.
At Some Point Facts Have To Matter
There are some questions that any investor should ask before swallowing the pain pill being offered up by the media.
Does an inverted yield-curve tell us a recession is coming?
Can banks make money with an inverted yield-curve?
Is there a better indicator for future growth and optimism?
Yield Curve Recession Predictor: A trending topic for recession watchers is the inversion of the yield curve. An inversion simply means that short term treasuries like the US 2-year pays a higher rate than long term treasuries like the US 10-year. I don’t see this as an indicator of a pending recession or even an indication to sell equities. In every instance in the past where the yield-curve was said to predict a recession, the lag time was up to 2 years before the recession started. There is no value in knowing that a recession may happen 2 years in the future. As investors we need an accurate gauge that tells us what to do now.
The U.S economy is currently the best place to invest globally and this is attracting large inflows from overseas and domestically. Most of the developed world has negative rates for their treasuries, while the US is paying 1.5% on a 10 year bond and more on 2 year and 30 year bonds. As investors buy more long term bonds, the interest rate on those bonds comes down and much of this buying is forced (pension funds, governments, etc). At the same time the purchase of Treasury securities by the Federal Reserve as part of its quantitative easing program collapsed the rates on longer-dated Treasury bonds. The Fed has performed its own analysis of the impact and estimates that the $1.5 trillion of QE purchases of Treasury securities reduced the term premium about 60 bps. The Fed has subsequently allowed about $300 billion of Treasury securities to roll off its balance sheet, but the yield on the 10-year Treasury security today is still far lower than it otherwise would be.
The yield curve alone is never enough information to predict a recession. It is one of several economic indicators that need to turn negative, including increasing inflation and job losses, deteriorating credit, manufacturing index turning negative, and decreased earnings and housing starts. Credit Suisse recently put out their recession watch dashboard (see below), showing only the yield curve going negative (and likely artificially) with the other signals still showing strength, supporting my view that there is no imminent recession.
At some point, though, we will have a recession, and some of the biggest gains investors realize are from holding positions and establishing new ones during recessions.
Can Banks Make Money: Common thinks says, banks are evil, they make too much money and we should regulate them to conform to our ideals. Let's keep in mind that banks are the life blood of any economy. Banks create liquidity in the economy by lending for cars, homes, student loans, personal loans, small business and large businesses. One might infer then that if banks are doing well, then the rest of the economy should be doing well too. "The Economy" is not "Your Economy", let's keep those separate for now. In general lending is pretty good right now, while below longer term averages because of low interest rates, it's still good. Banks actually lend based on their cost of lending vs the default risk. The greater the spread between a banks cost of lending at what they can earn, the more likely the bank is to lend. Low or high rates alone don't increase lending.
The 10-year treasury was created in 1953. According to the theorists, for the inverted yield curve to have any relevance to the economy it must invert and stay inverted for a full quarter or more. In the 66 years since 1953 the yield curve was inverted in 22 quarters. We have not had 22 recessions since 1953, so the track record is sketchy. In the period from 1966-1981, 17 of those inversions occurred. There were only 5 inversions in the other years.
So what happened in that period from 1966-1981? The Vietnam war escalated and was paid off, President Johnson initiated the Great Society program, the country committed itself to building 26 million housing units over 10 years, a barrel of oil in 1966 was $3, by 1981 it was $30. It was an aberrational period in American history. Therefore to draw conclusions from that period and apply them to today is a stretch, conjecture, in short, nonsense theory. Academics have drawn conclusions from a set of data and the media popularized this idea to the point that I hear people talking about the yield-curve in line at Starbucks. When my deli counter guy tells me a recession is coming because the yield-curve inverted, I have to ask him, "What's the yield-curve?" "Well, it's that thing that guarantees a recession is coming".
In every year during those 17 inversions from 1966-1981 banks earnings went up. So when someone gets up and says there’s going to be a recession or we will have a problem with bank earnings because of an inversion of the yield curve, that’s theory, it has nothing to do with fact. There is little likelihood that the inversion of the yield curve that is occurring in this period is similar to the ones that occurred in prior periods, or that it will lead to a recession.
What's Happening Now: What’s happening in this yield curve inversion is that we’re getting a flow of money into the long end of the curve (10-year treasuries), pushing rates down; while the short end (2-year & 90-day note) is held up artificially by the Federal Reserve. In every one of the yield curve inversions going back to 1953, the short end of the curve went up either because of inflation or the Fed raising short term rates too high and too fast because of a strong economy. Where it was a shortage of funds that caused inversions prior to this one, it’s a surplus of funds causing this one.
That means that the inversion this time is due to a flow of money
into the US economy, and that is not going to create a recession.
What's The Better Indicator: When you go for a long drive and the gas gauge indicates half-full, does that tell you that you're halfway to your destination? Of course not, you look at the GPS or a map to determine where you are.
Likewise the 10's vs 2's tells an investor nothing about where we are relative to a recession, or more importantly where we are in the business cycle. The latter is all we should really care about.
When the Fed cuts rates they are essentially putting more gas in the tank. If we look at the economic dashboard again and look at the metaphorical GPS of the business cycle it's clear that we are still mid-cycle and not headed for a recession.
One of the best indicators, and there are many, is the High-Yield Corporate bond. A high yield bond’s price/yield reflects the market’s view on the underlying company’s ability and willingness to make interest and principal payments on its debt. It is intuitive, therefore, that the performance of the high yield market is positively correlated with economic growth/business cycles. This assertion is confirmed in a detailed analysis done by the NBER, the definitive source for US business cycles.
Overall high yield bonds reflect optimism/pessimism in the future for business growth, businesses ability to borrow and the bond markets confirmation that there should be near term growth in business. In fact these are the current conditions.
The chart below shows the largest high-yield bond fund, the HYG. If we were end of cycle, high yield bonds would be tanking, if we were late-cycle high yield bonds would be peaking. With most other economic indicators confirming strength, the chart below, indicates that high-yield bonds are doing fine and in fact growing a little each month, indicating we are still mid-cycle (the green region). On the left side of the chart we can see where high yield bonds peaked in 2007 and then crashed into a trough in February 2009 ending the previous business cycle. Above the green region is what we would call ‘late cycle’ and below is ‘end-of-cycle’. The graph clearly shows that we are ‘mid-cycle’ and most other metrics are supporting this position.
All the data continues to support investing in stocks. However, we've talked ourselves into down turns before, and we're likely to do it again. The solution? Turn off the financial news or learn to separate news from noise. Please, do not chase after rallies in the stock market, be a buyer when the market is down. Be a bargain shopper. If you're just starting out, wait for a solid decline of 500 points or more and buy an index fund like the Vanguard Total Stock Market Index (VTI). This is the set it and forget it fund that keeps you invested in the total US stock market. It's you're savings account and should receive a contribution from every pay check. Over time you will dollar cost average your way to a good position that should deliver 8-10% annually. Of course you want to automatically re-invest dividends. The blog portfolio provides another way for average investors to diversify their investments into an index fund, gold, utilities, dividend stocks and growth stocks. The blog portfolio as a whole is lower risk than most money managers, doesn't have the fees of a professional adviser and so far has delivered better returns every year since 2016 through good and bad markets.
Men Need Your Help
For three years I've hosted a Distinguished Gentlemen's Ride in support of men's health. On Sunday the 29th of September, for the fourth year, I will don my finest attire with my fellow men and women across the globe to join the fight with The Distinguished Gentleman's Ride to raise awareness for prostate cancer and men's mental health. But before I press my tweed and polish my boots, I need you to donate what you can for this meaningful cause and help me reach my goal.
For your uncles, your brothers, your fathers and friends.
Donate what you can, for their lives need not end.
This year I'll be traveling to Ukiah, CA to support a new DGR Ride hosted by David and Martha Bookout. The DGR Ride is a program of the Movember Foundation. Movember seeks to make a global contribution to men living happier, healthier, longer lives. It is the driving force behind their campaigns, funding strategy, and vision for the future.
The state of men's health is in a crisis. By 2030 Movember aims to:
Reduce the number of men dying prematurely by 25%
Reduce the rate of male suicides by 25%