Thoughts on Markets

Yield Curve Inversion - What is it and what it means

August 15, 2019

If you were anywhere near financial news yesterday, you likely heard the term yield curve inversion more than a few times and observed a sharp equity sell-off.  We thought it was worth explaining what that term actually means – and why it may matter for investors

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What are bonds again?

The global bond market represents trillions of dollars.  Bonds are financial instruments that companies and governments use to borrow money.  Every bond represents a promise to repay, plus a stated rate of interest for use of the funds over time (referred to as a yield or interest rate).

Wait, how is this different than a stock?

Stocks do not include any promise of repayment.  Instead, stocks represent a share of ownership in a business.  As an owner, you receive your pro rata share of the company’s earnings and growth over time

Got it.  Back to bonds - how are bonds priced?

Again, bonds are a promise to repay issued by a company or government.  Bonds tell a story about the underlying issuer as it’s important to know how likely they are to repay you.  A riskier issuer tends to have to pay more (ie: a higher yield) than a less risky issuer.  In addition, an issuer borrowing money for a longer period of time is willing to pay more (as investors want to be compensated for locking up money for longer and an issuer is willing to pay up to have access to those funds for a longer period)

What’s a yield curve?

The US government is one of the world’s largest bond issuers, with promises to repay at a variety of maturities (from 30 days all the way to 30 years).  The yield curve is the progression of US bond interest rates over the various maturities.  Said another way, if you plotted out the interest rates on each of the US debt maturities on a graph from shortest to longest in a “normal” state, the curve would steadily rise left to right.   Why?  Investors typically demand a higher return for locking up their funds for a longer period of time than a shorter one (and the US government is willing to pay more to have access to funds for a longer period of time).

So in steady state, the rate the US government will pay on a 10-year bond is higher than the rate they pay on a 2 year bond

What’s an inversion?

A yield curve inversion is when the graph we described above slopes downward, implying that shorter maturities pay more than longer maturities.

We saw this happen yesterday, when the rate on the US 2 year bond fell below that rate on the 10 year bond.  

How did this happen?

Bonds trade in the open market, just like stocks, and the pricing of them is driven by supply and demand.  If demand is higher than supply, the price goes up (and the yield thereby goes down as there is an inverse relationship between the two).  So, in recent weeks/months, there has been a higher demand for the 10 year bond than the 2 year bond.  This drives the price of the 10 year up (and the yield down). 

Why would investors favor the 10 year over the 2 year?  It seemingly indicates near-term uncertainty in the US’ promise to repay and implies more value in the 10 year promise versus the 2 year promise, as well as a desire to lock in that offered rate over 10 years

Why did stock markets react?

An inversion of the 2 year/10 year yield curve has been a predictor of recessions in the past, with the recession coming approximately 2 years after such an inversion.  Even though the inversion lasted only part of the trading day, it was enough to cause recession worries, trigger quant funds and algorithms, and lead to considerable equity selling

Is a recession a sure thing?

First, remember what a recession is.  It is NOT two quarters in a row of negative real gross domestic product (GDP) as is commonly believed. 

Rather,   a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” 

There are many data points that have been examined in hindsight after recessions that are now believed to be valuable predictors.  The 2 year/10 year yield curve inversion is one of these metrics.  Recessions has always followed a yield curve inversions - but remember there are also cases where the yield curve has inverted and a recession has not followed.   .

Any good news?

There is always good news. First, a decline in rates is excellent news for borrowers. If you have any debt (like a mortgage), you may want to look into refinancing at these lower rates. Second, while there is a lot of uncertainty and volatility, there remains many positives in the US and globally. If you are an investor and not a trader, you have prepared for this and can endure these moves. Stay focused and don’t rush to react.

View from the Chair: Windermere's Market Perspectives (August 2019)

What is happening?

August is traditionally a slow month - as we ease from summer fun back into the routineness of fall. Not this year, at least as it relates to the markets.

In case you’ve tuned out business news for the past week, here is what you’ve missed:

*What goes up is coming back down - last week, the US Federal Reserve lowered the Federal Funds Rate by 25 basis points. Yes, that’s the same benchmark rate that the Fed increased several times last year at a faster than expected rate, leading (in part) to December’s sharp selloff. This recent rate cut was believed to be in response to trade concerns and slowing growth (as lower interest rates should lead to more borrowing and in turn more growth). Markets were tepid in response as they had priced in ongoing rate reductions (which the Fed did not indicate in comments)

*”Tariff Man” strikes - President Trump has given himself this title and he put it to use again as he announced that he would extend tariffs to virtually all remaining Chinese imports not yet subject. Many believe this was in response to China not ramping back up purchase from US ag suppliers/farmers

*China responds in force - Markets woke up Monday (8/5/19) to news that China had devalued its currency (allowing the Yuan to fall below the previously accepted floor of 7 yuan to USD). This sparked an immediate reaction in global markets. China’s central bank said that the currency move was due to economic factors/trade concerns and was not retaliatory. Yet markets clearly viewed it as a sudden increase in trade tension and uncertainty. Why does this devaluation matter so much? As the yuan falls (relative to other currencies, including the USD), it makes Chinese goods cheaper on a relative basis, thereby inherently encouraging other countries to buy from China and discouraging them from buying from other countries, including the US. It was also seen as a extreme tactic, indicating that trade disputes are likely to continue.

*Currency manipulation - President Trump immediately tweeted that China was a currency manipulator and later on Monday, upon reviewing the facts, the US Treasury declared that China was in fact just that. What is required to achieve that label (which is mostly symbolic)? Three factors are considered: (1) country must be known to actively intervene in its currency markets (2) country has a large trade surpius with US and (3) country has a large overall current account surplus. All are true for China

*Not so fast - First thing Tuesday, after the worst day of 2019 for equity markets and treasury yields falling to levels not seen since 2016, China retraced its steps (a bit). China’s Central Bank indicated its desire to keep its currency at a higher level. This statement eased worries that China is intending to use its currency as a weapon in the trade war and markets gained back some of the large decline on Monday

Where does that leave us?

A few truths appear self evident to us:

1) Worthy adversaries - both the US and China are incredibly strong nations with their own unique share of bargaining chips. Much has been debated about who is in a weaker position but it is clear that both are willing to negotiate and stand their ground on behalf of their countries

2) Open negotiations - one has to imagine that before twitter and 24/7 business news, trade negotiations between two world powers such as these would not be dissected and analyzed minute to minute. The media scrutiny and reaction to every back and forth is intense - and should be viewed with extreme caution. A negotiation is just that - a negotiation. It is not (and will not be) an open and shut debate

3) Much at stake - The US has a lot at stake (as does China). But taking an objective view of this, the US does have a trade imbalance with China and has been suffering intellectual property theft for many years. While you may disagree with the tactics (ie: tariffs), the spirit of the issue has recognizable merits

4) Outcome is likely but not on the imminent horizon - It is highly likely that an outcome will be reached. Trump faces a pending election (and while we’d like to think politics don’t play a role, we all know that they do) and China needs to boost its economy and retain growth. A deal will come but we don’t believe it will happen for at least a few months (if not into 2020)

What’s an investor to do?

The time to prepare for a fire is not the day the fire strikes, so to speak. In balanced portfolios, we have been trimming equity weights and building fixed income positions. We’ve also been retaining some cash to add on weakness, such as this, from our “shopping list” of companies as well as skewing equity holdings to larger cap names with a more defensive tilt. And we’ve been ensuring that any liquidity needs are “stored” in cash/fixed income and/or covered by yields.

Best thing you can do is to pause and consider what action you are tempted to take and why. Then give us a call and we can walk thru it together before you do anything. Investors are often most tempted to do the exact wrong thing at the exactly wrong time. Let’s work together to avoid just that.

Invest on - and know you are not in this alone,

Pam