Investing with an inverting yield curve: should you expect another financial crisis?
By: Duino S.
Tags: Debt, Society, Investing, Economics, Finance

Ten years after the big crash of 2008 and after a bull market that is going on for 9-years, as we are approaching the end of 2018 we have been seeing significant corrections in the stock market while bond returns are rising.

Interest rates are gradually rising and every one has its eyes on the next move by the Federal Reserve.

In this article, we are going to first discuss what the recent declarations by the FED mean when it comes to the current economic situation, then we are going to look at why the yield curve is a pretty good indicator to forecast a recession.

As the years is coming to an end, there are two important pieces of information for investors that came out recently:

The FED turning from a hawkish to a dovish position

The Yield Curve that is inverting

Those things are really some of the keys to identify potential scenarios for the near future.

Let’s take a closer look in order to understand what it means.

Federal Reserve and Interest Rates

Just recently the FED changed its rhetoric using softer tones to describe the position of the monetary policy, in fact at the end of November 2018 the chairman of the Federal Reserve Jerome Powell said:

“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy — that is, neither speeding up nor slowing down growth”

The federal reserve has a range of estimates for the neutral interest-rate between 2.5% and 3.5%, today interest rates are approaching 3% (“just below” the neutral level)

This doesn’t mean that hikes for 2019 are going to stop, but it means that they will pay close attention to what economic and financial data are telling and that clearly suggests lower interest rates hikes for the future.

The change in the position of the FED means that they looked at the economy and realized that if they raise interest rates the market would crash, and they obviously don’t want to cause the crash.

The immediate reaction of the markets after the declaration was positive because they were pricing the expectation of higher interest hikes, but that decision by the FED confirms the fact that the economy is slowing down and that economic data are not that good, and this is something that sooner or later will be priced by the market.

That is precisely described in the FED minutes when talking about uncertainty and elements of risk.

Here is the comment about the medium-term outlook for economic activity, the labor market, and inflation over the medium term.

“A couple of participants noted that the federal funds rate might currently be near its neutral level and that further increases in the federal funds rate could unduly slow the expansion of economic activity and put downward pressure on inflation and inflation expectations.

A few participants indicated that uncertainty had increased recently, pointing to the high levels of uncertainty regarding the effects of fiscal and trade policies on economic activity and inflation.

Several participants were concerned that the high level of debt in the nonfinancial business sector, and especially the high level of leveraged loans, made the economy more vulnerable to a sharp pullback in credit availability, which could exacerbate the effects of a negative shock on economic activity. The potential for an escalation in tariffs or trade tensions was also cited as a factor that could slow economic growth more than expected.”

While I talked extensively about how those good reasons for the coming economic recession may lead to an economic downturn in the near future, when you look at history when the FED pushed interest rates above the “neutral level” a recession followed soon after.

Source: Zerohedge, based on Bloomberg Data

In the effort of unwinding QE, the FED might be the catalyst that ultimately crashes the market and it is quite likely since every tightening cycle ended with a crisis.

No central bank wants to be responsible for a crash (while surely they are among the major responsibility for the creation of bubbles), this is why the position of the FED is so fragile.

This brings us to the other key element to watch out.

Inverting Yield Curve

The yield curve is a relationship between the interest rates of bonds of equal credit quality with different maturity dates.

The yield curve can have three kinds of shapes: normal, flat and inverted.

The normal yield curve indicates that bonds with a longer maturity have a higher yield compared with shorter-term bonds because of the risks associated with time.

A flat curve indicates that the short and long-term yields are very close to each other, a sign of a certain degree of uncertainty about growth and it generally indicates times of economic transition.

When the yield curve is inverted, short-term yields are higher than long-term yields. This means that uncertainty about the near future is high and investors expect lower interest rates for the years to come or, in other words, they expect lower economic activity in the future.

The information of the yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and the shape of the curve is a pretty accurate indicator for predictions of changes in economic output and growth.

As an investor, you want to pay close attention to the shape of the yield curve because from empirical evidence, every time that the curve inverted there has been a recession.

The yield curve can be used to perform economic forecasts, here is what the Federal Reserve itself has to say:

“The term spread — the difference between long-term and short-term interest rates — is a strikingly accurate predictor of future economic activity. Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession. While the current environment is somewhat special — with low-interest rates and risk premiums — the power of the term spread to predict economic slowdowns appears intact.”

The evidence is presented in this chart. The term spread is calculated as the difference between ten-year and one-year treasury yields from January 1955 to February 2018, shaded areas for officially designated recessions.

As you can see, every recession over this period was preceded by an inversion of the yield curve, that is, an episode with a negative term spread.

Source: Research from Federal Reserve Bank of San Francisco; FRBSF Economic Letter 2018–07 “Economic Forecasts with the Yield Curve”; Michael D. Bauer and Thomas M. Mertens

Again, on the empirical relationship between economic activity and term spread, the FED research said:

“A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.”

Toward the end of the economic cycle, when uncertainty towards the future starts to arise, the curve flattens because investors expect lower economic activity and lower interest rates in the future, therefore they want to lock in the higher interest rates of that are available in the present to avoid lower returns in the future.

As they buy long-term bonds to do that, returns on long-term bonds decrease while returns on short-term bonds get higher. When this happens, it signs a recession ahead.

Right now, we have an almost flat yield curve where interest rates relative to all maturities, from 2 years to 30 years, are converging at 3%

This means that today you get roughly the same return for a 2-year treasury and a 30-year treasury.

When the curve is inverted, the interest rate on a long-term bond is lower than the short-term bond and investors prefer long maturities to the uncertainty of the short term.

From a historical point of view, every time that the yield on short-term maturities was higher than long-term maturities, a recession showed up within 6 to 24 months.

Here is the difference between the yield of a 10-year treasury and the 2-year treasury. When it is below zero the term spread is negative and every time that the term spread turned negative an economic slowdown promptly showed up.

Right now we are at 0.26 and the trend points directly below the zero level.

This means that the risk of a recession is very high and investors are starting to chasing to lock in long-term fixed returns on bonds.

To recap, different indicators show that we have:

Economic data that signal a recession

A high level of debt, especially in the nonfinancial sector

Stock market valuations at record highs

Not a good combination to be in.

How to invest in this environment?

Monetary policy remains accommodative but clear signs of uncertainty are arising. The 9-year bull market of stocks has slowed down in the last few months, hinting an inversion.

The FED is doing everything to postpone the recession, keeping lower interest rates and continuing the stimulation of high leverage made possible thanks to low-interest rates.

High levels of debt and leveraged loans were clearly identified as high-risk factors for financial stability from the FED. Basically, they are avoiding short term pain and risking worst consequence in the future.

When the next recession comes, the monetary stimulus will be way less effective than 2008 because they can’t cut interest rates that already are very low. As you can imagine, the situation of postponing a crisis can’t last indefinitely, it is not sustainable in the long-term and sooner or later it will come to an end.

In light of this economic perspective, you might consider how to position your portfolio over the long-term. Beware of companies that have very high levels of debt because they are the ones with the highest exposure to credit availability if liquidity tights refinancing becomes a big issue. Consider having some hedges, like commodities, and look for businesses with real assets that can withstand well and economic downturn.

Finally, when uncertainty is so high, it makes sense to have a significant amount of cash for two reasons: you are less exposed to market fluctuation and you put yourself in the position of being able to buy assets with a significant discount when the opportunity comes.