The second quarter of 2019, as seems to be the case with most quarters of the last few years, saw its share of volatility and contradictory data points. For stocks, the worst May in almost a decade was followed by the best June in about 50 years. Any negative data points in areas such as housing or manufacturing have been offset by positive numbers in services sectors and employment numbers.
During the second quarter, bonds and stocks appeared to be watching two different economies. Sovereign bonds (government-issued debt) appeared to see the world as a glass half empty, and equities saw the world primarily as a glass three-quarters full.
The gloom that bonds saw was reflected in about $14 trillion of global sovereign debt having a negative yield. Negative yielding bonds reflect an investor’s desire for return of their money over a return on their money. Additionally, the yield curve in the United States is flat or inverted, implying the possibility of slowing growth or recession.
Source: Bloomberg LP. Rates of the Country Government-issued bonds with 2, 5, 10 and 30 year maturities.
While bondholders were concerned about the return of their money, stock investors had a sunnier disposition, focusing on the return on their money. Stocks were moving to new highs on the hopes of a dovish pivot by the Fed and some resolution to the trade conflict with China.
Enter the third quarter with global trade uncertainty and messy Brexit negotiations hampering confidence and changing the calculus around the Fed’s rate trajectory. In December, when the Fed last raised rates 25 basis points, a trade deal with China seemed a likely outcome, Theresa May was still negotiating a soft Brexit, and the Cardan aggregate yield curve was falling toward inversion (but had not yet actually inverted). A rate hike to normalize policy in a strong economy was a rational stance — but how the world has changed in about six months. There is now talk that China is willing to wait out the Trump presidency in the hopes of a different president to negotiate with in 2020, Boris Johnson now occupies 10 Downing Street and is committed to a hard Brexit, and the Cardan aggregate yield curve is now inverted.
Central Banks globally are easing, and the Fed has joined the process. The complexity and uncertainty of the trade war and the Brexit negotiations factored into the Fed’s rate cut decision. Chairman Jerome Powell described the first cut in more than a decade as a “mid-cycle adjustment,” so market participants regarded the move as a “hawkish cut” and interpreted it rather bearishly. A mid-cycle adjustment was not what the market was looking for. It instead was looking for the beginning of an easing cycle as participants now view the world with far greater uncertainty and want the Fed to ride to the rescue.
As of the beginning of August, the 10-year Treasury has fallen below 2%, a sharp contrast to the breathless calls for raising rates just last year. Falling rates globally is an additional sign that the sovereign bond markets are concerned about future global growth. At this juncture, the bond markets’ interpretation of the economy from the second quarter seems to be more prescient than that of the stock market as more things seem to be unraveling than being put back together.
Source: Bloomberg LP. Central Bank policy rates of the different countries/regions and their last rate decision.
Since the Fed’s rate cut on July 31, 2019:
- President Trump announced 10% tariffs on $300 billion of Chinese goods.
- China said they won’t buy U.S. agricultural products.
- The U.S. Treasury Department labeled China as a currency manipulator.
The U.S.-China trade war’s ceasefire has ended. Both sides are taking shots to prove they don’t intend to flinch. However, the danger of overplaying one’s position cannot be overstated.
This whirlwind of geopolitical activity and rapid succession of news events can be fatiguing. Each seemingly important headline is superseded by a new, more important headline 24 hours later. The frenetic news cycle is not informing our investment decisions. However, if a headline is consequential to the economy, it slowly but surely seeps into the economic machine. The impact, positive or negative, will be registered in the markets and the economic data we monitor.
In this environment, what was an overbought stock market is starting to correct. As the salvos in the trade war ramp up, the stock market may suffer a bit more weakness before finding its footing. The bond market is doing its job as a ballast to portfolios. We think it is not yet the time to move defensively because the market is oversold and has room to rally.
Recessionary pressures seem to build with each month that the yield curve is inverted. On the other hand, employment remains solid, and consumers continue to spend. As we recently said to a client, “The party is not yet over, but we are dancing very near the door.” If our signals are activated, allocations will be repositioned to become more defensive to protect from the normal behavior of markets in recessionary periods. Recessions are notoriously hard to predict, let alone time, but the data are starting to look as though we may be past the tipping point.
The Recession Watch Line (blue line in chart below) is meant to monitor whether the overall U.S. economy is weakening and possibly approaching a recessionary period. This line is coupled with the 1/10-year Treasury yield-curve spread (dark blue line in chart). As both these lines approach zero, the economy is closer to a potential recessionary period. The line peaked in September 2018 and has trended lower in general since then. The 1/10 Treasury spread inverted in May.
Cardan Recession Watch Line
Disclosure: Data sourced from Bloomberg LP. Recession dates defined by the National Bureau of Economic Research (NBER). 1/10 curve spread is the spread between the 10-year and 1-Year Treasurys The Cardan Recession Watch Line relies on economic indicators to detect if the overall U.S. economy is weakening and approaching a potential recessionary period. It is an internal forecast only and not meant to be relied upon for consumer trading decisions.
The average of yield curve spreads and the total number of inverted curves can be more indicative of a potential recessionary period than simply analyzing any one spread in isolation. The aggregate average yield has inverted (moved below zero), and more than 75% of the curve spreads monitored are inverted. This is an important threshold for signaling future economic headwinds.
Yield Curve Inversions
Disclosure: Data sourced from Bloomberg LP. Recession dates defined by the National Bureau of Economic Research (NBER). 1/3 is the spread between the 3-year and 1-Year Treasury; 3/5 is the spread between the 5-year and 3-Year Treasury; 2/5 is the spread between the 5-year and 2-Year Treasury; 3M/5 is the spread between the 5-year and 3-monthTreasury ; 2/10 is the spread between the 10-year and 2-Year Treasury; 1/10 is the spread between the 10-year and 1-Year Treasury; 3M/10 is the spread between the 10-year and 3-month Treasury; Fed Fund /10 is the spread between the 10-year and Fed Funds rate (i.e. central bank rate). Data is for illustrative purposes and not meant to be relied upon for consumer trading decisions.