An Updated Look at the Yield Curve and Stock Market Volatility

Friday the market once again plunged big time.  One thing I neglected to mention in last night's update is that both the Dow and the S&P entered the official 10 percent correction on Friday, the Dow having lost 10 percent from its high October 3rd, the S&P having lost 11.3 percent from its high in September.  And this week the notorious inversion yield curve has been all over the financial news, that is the point at which the 2-Year T-Bill pays more than the 10-Year T-Bill, something economists say has called every recession of the last 50 years.  This is being taken with sufficient seriousness that another major story on Friday was that 40 percent of economists surveyed by Reuters are now calling for a recession in 2020.  Tomorrow, I will include an article published by Barry Ritholtz today where he demonstrates how historically the prognosticators warning of recession have almost always been wrong.  Tonight, it's more appropriate to include yet another article explaining this yield curve, this time courtesy of AAII.  Enjoy your weekend.  Temps won't be in the 40's much longer.


Sat 12-15-18 AAII Investor Update: Yield Curve

An Updated Look at the Yield Curve and Stock Market Volatility 

Thursday, December 13, 2018

Last week, the yield on the five-year Treasury note fell below that of the two-year note. Any investor could have realized a higher yield for tying up their money for only two years rather than for five years. The yield curve—which plots the interest rates for Treasuries of varying maturities—is not supposed to work this way. Under normal circumstances, investors demand higher rates of return for parting with the money over longer periods of time.

Over the seven-day trading period of December 3, 2018, through December 12, 2018, the relative yield of the five-year Treasury compared to its two-year brethren has ranged between a low of –3 basis points (–0.03%) to a high of zero. The negative difference indicates an inverted yield curve (the curve slopes down from shorter to longer maturities) while the equal yields indicate a flat yield curve (the curve resembles a straight line).

The inversion of the five- versus two-year yields drew attention when it first occurred last week. Lower yields for longer-dated Treasuries relative to shorter-dated Treasuries suggest traders expect economic conditions to soften, thereby easing inflationary pressures. If, in contrast, they expect inflation pressures to intensify, they would demand higher yields on longer-dated bonds to compensate for the expected loss of purchasing power.

While the two- to five-year rates got attention, the bigger yield comparison to watch is the two-year Treasury note versus the 10-year note. This is the yield curve I discussed back in May. An updated version of the chart is shown to the right. While the 10-year note continues to yield more than the two-year note, the gap is narrowing.

Many market observers watch how this part of the yield curve changes over time because it can be an economic canary in the coal mine. Since the mid-1970s, every economic recession in the U.S. was preceded by an inverted yield curve, observed Michael W. Klein of Tufts University on the EconoFact website. Specifically, recessions followed periods when the 10-year Treasury note’s yield fell below that of the two-year note’s yield. In such scenarios, you could get a higher interest rate for locking your money up for just two years as opposed to 10 years.

Though the yield curve measured on this basis has become flatter, it has yet to invert (meaning yields on the 10-year note are higher than those of the two-year note). Even if the curve were to invert, it does not mean a recession is imminent. Rather, prior to the 2008 financial crisis, the length of time between inversion and the start of the recession has varied between 10 and 18 months. Plus, the relationship is not causal. Inverted yield curves don’t lead to recessions but rather reflect heightened fears about the possibility of a recession occurring—a big difference.

It’s within the range of possibilities for a pausing of rate hikes by the Federal Reserve to impact trader’s sentiment and thereby the slope of the yield curve. The CME’s FedWatch Tool assigns less than 25% odds of more than one rate hike occurring next year. A quarter-point rate hike should be announced at next week’s meeting and then potentially just one more next summer. The futures market is pricing in less than a 25% probability of a second 2019 hike occurring. These forecasts are subject to change.

A separate, though related, indicator of recessions is housing starts. Seven out of the last eight recessions were preceded or accompanied by a drop of at least 30% in housing starts according to Sam Stovall, chief investment strategist at CFRA Research. Though the housing market has weakened, it’s nowhere near recessionary levels. Housing starts in October 2018 were down just 2.9% from October 2017. November data will be released on Tuesday.

As far as the stock market’s volatility is concerned, any perception you may have of it intensifying over the past two months is justified. Since October 11, the S&P 500 index has closed up or down by at least 2% on nine separate days. The full-year total for such moves was lower than this during four out of the last six years (2012, 2013, 2014 and 2017). In total, 2018 has incurred 16 days with a daily change of more than 2% and 57 days with a daily change of more than 1%. When volatility is measured on an intraday basis, it remains lower than the average amount realized since 1962 according to Howard Silverblatt at S&P Dow Jones Indices.

The market feels more volatile now because it is coming out of an extended period of relative calm. We haven’t experienced a volatile year since 2011, which saw 35 days with a move of more than 2% and 96 days with a move of more than 1%. Relative to last year, which saw no days with a 2% closing change or a 2% intraday swing, 2018 feels like a rollercoaster.

Spikes in volatility do not always precede recessions. To quote Benjamin Graham, “in the short run, the market is a voting machine.” Traders tend to act first and ask later. While the stock market is forward-looking, it often sways too quickly and too far. So rather than reacting to it or the bond market, take a long-term view and consider a broader range of indicators than what is discussed in the daily and real-time news headlines.