The Yield Curve And Stocks: Much Ado About Everything
Gary Gordon | Jul 11, 2018 02:43PM ET
There has been a great deal of chatter about the strength of the American job market. And with good reason. Most measures of employment health – U-2 unemployment rate, jobless claims, wage increases, year-over-year job growth, etc. – support the notion that U.S. workers are “winning.”
On the other hand, very few folks have addressed the possibility that the data are more likely to weaken than strengthen. On the contrary. So much faith is being placed on tax cut stimulus that few discuss the potential erosion of employment prospects.
For example, when the U-2 unemployment rate in May hit a business cycle low of 3.8%, the financial media cheered. When it rose to 4.0% in June, the media applauded even louder, surmising that it was a sign that more people were coming back into the labor force.
Down is great? Up is great? What, then, would be a poor month for unemployment data?
There is, of course, another explanation. Perhaps 3.8% represented a business cycle unemployment low. In fact, unemployment rate troughs tend to precede economic contractions and/or stock bears by about one year.
The unemployment low in the previous expansion was 4.4% (October, 2006). The recession officially began in December of 2007, while the bear market for stocks began in October of 2007.
Similarly, a U-2 unemployment low of 3.8% occurred in April of 2000. Ironically enough, the stock bear had already started in March of 2000 and the recession was only one year away (March, 2001.)
Dig a little deeper into recent history and one discovers a variety of intriguing observations. For example, sharp slowdowns in job growth have preceded recessionary environments. This transpired in 2000. It also occurred in 2007 leading into the financial collapse.
What is not necessarily talked about is the timing of precipitous slowdowns in job growth. For example, the inversion of the Treasury bond yield curve in 2000 and again in 2006 seemed to kick off dramatic retreats in year-over-year percentage job increases. Eventually, job growth turned negative alongside economic recessions.
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Keep in mind, since the 1960s, yield curve inversion has successfully foreshadowed all seven of the recessions that came to pass. In other words, for whatever reason(s), when shorter-term interest rates have yielded more than longer-term interest rates, economic contraction has followed within a relatively short period of time.
Is it possible that when the Federal Reserve is removing market liquidity and raising shorter-term borrowing costs, employers become more skittish? Do companies put the brakes on hiring plans? Maybe.
What appears abundantly clear is that Fed Chairman Powell appears resolute on moving forward on a twofold tightening path. He is going to continue raising overnight lending rates. And he is going to follow through on the reduction of balance sheet assets.
Theoretically, raising the overnight lending rate might not be as big a deal if longer-term debt maturities were rising in tandem. Yet, they haven’t been. The 10-year yield has actually fallen 20 basis points since the Fed last raised its overnight target to a range of 1.75%-2.00%. That has left a paltry difference between 10-year Treasury yield and 2-year Treasury yields at 0.28%.
Why is it important to take note of the fact that the curve’s flatness as well as the prospect of yield curve inversion is partially a function of longer-term bond yields falling? For one thing, the economy is supposed to be firing on all cylinders. For another, wage inflation is supposed to be ticking higher. Additionally, the tax cut stimulus involves the issuance of more Treasury debt, adding to supply. What’s more, the Fed’s quantitative tightening is also increasing in the supply of available longer-term maturities where their corresponding rates should be climbing. In other words, if everything is so awesome, why wouldn’t the curve be steepening instead of flattening?
Granted, if the spread between the 10-year and 2-year does go negative, a recession is not guaranteed. Seven out of the last seven recessions? Sure. Still, it is possible that the eighth time will hold no significance whatsoever.
It is also plausible that yield curve inversion may present a much bigger lag than the often cited 12-month lead time. Perhaps it will be 24 months or 36 months. And if that’s the case, stocks may have a whole lot more room to run.
Then again, even when recessions are not imminent, stocks have a tendency to worry about the future before it transpires. And in some cases, asset price depreciation itself leads to self-fulfilling prophecies. Indeed, the bursting of the tech bubble in March of 2000 led to the layoffs and the eventual recession that followed, not the other way around.
For the investor, then, I am not sure how much it matters why the inversion of the yield curve tends to be bad for stock assets. I just know that when it happens, adding additional investment risk may be inopportune.
The broadest stock market indices may already be responding to the apparent inevitability of yield curve inversion. Consider an index that combines all of the stocks trading on the New York Stock Exchange, the NYSE Composite. Not only has it been range-bound since the January correction began, but its year-to-date performance is essentially 0%.
Perhaps ironically, the S&P 500 is currently up 4% year-to-date and the index remains within spitting distance of its all-time highs set in January. However, the reason for its superior performance is disconcerting for a variety of market watchers. Why so troubling? The market-cap weighted S&P 500 owes virtually all of its 2018 gains to the FANG-plus phenomenon.
In fact, Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Alphabet/Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) account for 98% of the S&P 500’s success this year. Absent their presence, the S&P 500 would be sitting on 0% gains in much the same way that the NYSE Composite now sits.
The good news? Most domestic indexers have quite a bit of exposure to FANG-plus in their portfolios. That means they are currently outperforming tech-shy active managers, value indices as well as international stock enthusiasts.
The bad news? Most domestic indexers will get whacked should anything go wrong with the hold-n-hope, FANG-plus paradigm.
From where I sit, yield curve inversion is likely to take a fairly dramatic toll on job growth. Downward pressure on stocks would follow suit. And over-leveraged ownership of FANG-plus securities could result in a wave of margin calls, forcing the liquidation of the investment world’s most desired shares.
Did you have a plan in 2000? Did you have a plan in 2008? Even if catastrophe never comes to fruition, planning ahead for the possibility of extremely difficult outcomes is financially astute.
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