Succinct Summation of Week’s Events 12.7.18 (plus that pesky yield inversion curve)
The usual weekly summation is below with the only significant positive being that weak labor and housing data might be signaling slower Fed rate hikes. The negative of course goes without saying -- it was a week of being trounced with all the indexes down at least 4.5 percent. Need I say more? The bonus this Sunday night is a primer on bonds that includes something that the market has been looking at very closely this week - the T-Bill yield inversion curve. As a reminder, this is where the curve for the 10 year note crosses below the 2 year note, something this week they are saying has happened before every recession of the past 50 years. They haven't crossed yet but this week they got closer. How many investors had even heard of the bond inversion curve before this week? So I thought I'd include this brief tutorial from the web site "babypips.com" to help lend some clarity. Hope everyone had a great weekend. Stay warm.
Succinct Summations for the week ending December 7th, 2018
Positives:
1. Federal Reserve sees Labor and Housing data as soft — indicates slower rate hike cycle;
2. Non-farm payrolls rose 155k in November, meeting the low side of expectations;
3. Unemployment rate remains unchanged at 3.7%.
4. MBA mortgage applications rose a seasonally adjusted 1.0% w/o/w
5. Non-farm productivity rose 2.3% q/o/q, meeting expectations.
6. ISM manufacturing index rose 1.6 in November from 57.7 to 59.3; ISM non-manufacturing index rose 0.4% m/o/m, from 60.3 to 60.7.
Negatives:
1. POTUS Tweets about a China deal turn out to be bullshit; market loses faith in POTUS;
2. Major Indices (S&P -4.6%; Nasdaq -4.9%; Dow -4.5%) suffer worst week since March;
3. International trade deficit deepened to -55.5B in November, 500M deeper than expected.
4. Layoffs came in at 53,073 for November for 3rd straight month of elevated layoffs.
5. Factory orders fell 2.1% m/o/m, down from previous 0.7% rise. Construction spending fell 0.1% m/o/m, missing the expected 0.3% increase.
6. PMI manufacturing index fell 0.4% in November from 55.7 to 55.3; PMI services index fell 0.1% m/o/m from 54.8 to 54.7.
Back in October,
the market was freaking out about surging U.S. bond yields.
And this week, U.S. bond yields are under the spotlight again since the market
is worried about this “yield curve inversion” thingy.
What’s a yield curve inversion, you ask? And why all the hubbub
about it? And what the heck is a yield curve in the first place? Well, all that
and more will be discussed in today’s little primer.
What’s a yield curve?
If you were able to read up on our school’s lesson on How Bond Yields Affect Currency Movements, as
well as my previous Primer On Government Bonds,
then you already know that bond yield just refers to the return on investment
from a bond and that rising bond yields ain’t really all that bad. In fact,
rising bond yields are used as a gauge for economic growth.
But what’s a yield curve? Well, a yield curve just refers to the
difference (i.e. the spread) in yields between bonds of the same quality but
different maturity dates.
And for the purpose of today’s little primer, “bonds of the same
quality” refer to U.S. government bonds.
·Treasury Bills: 1-month, 2-month, 3-month, and 6-month
·Treasury Notes: 1-year, 2-year, 3-year, 5-year, 7-year, and
10-year
·Treasury Bonds: 20-year and 30-year
The only real difference is that Treasury Bills are sold at a
discount and don’t pay interest before the maturity date (since interest is
paid semi-annually).
And finally, the “difference in yields” refer to, well, the
difference in yields.
And normally, longer-dated bonds have higher yields compared to
short-term bonds. And as you can see in the overlay below, for example, 30-year
bonds offer higher yields compared to 10-year bonds, 10-year bonds have higher
yields than 5-year bonds, and so on and so forth.
And
if you’re asking why, then you were probably sleeping when the concepts of
Maturity Risk Premium, Time Value of Money, and Opportunity Costs were being
discussed during your Economics class.
But if you genuinely don’t know or just forgot, then just ask
yourself this:
If a rich uncle you never knew about suddenly appeared and made
you choose between getting a $1,000 gift next month or getting a $1,000 gift
next year, which would you choose?
You’d obviously want to get the $1,000 by next month, right?
There are a lot of risk events over the course of a year after all, not to
mention inflation. Also, if you get that $1,000 now you could invest it and
probably have a bigger return.
But if the rich uncle changes his offer to a $1,000 gift next
month or a $2,000 gift next year, then you would probably stop and think about
getting that $2,000 gift next year instead.
Well, the same underlying principle is at work with regard to
bond yields.
And normally, if you plot the yield of bonds of varying
maturities, the yield curve would look something like this.
Again,
notice that as the maturity period increase (moves to the right), the yield
also increases (moves higher). Actual yield curves ain’t as pretty as that one,
though.
What’s a yield curve inversion?
Now that you (hopefully) understand what a yield curve is and
what a normal yield curve looks like, it’s time to discuss yield curve
inversion.
And yield curve inversion just means that
the yield of longer-term bonds go below the yield of shorter-term bonds.
Do take note that yield curve inversion and an inverted yield
curve are different concepts, to be more technical about it.
An inverted yield curve is the end result of a complete yield
curve inversion, which is to say that the shortest-term bonds now offer the
highest yields while the longer-dated bonds have the lowest yields.
Basically, we’re referring to a situation like the highlighted
area below. Do take note that 3-month bonds (purple) have the highest yield in
the highlighted area below, while the 30-year bonds (blue) offer the lowest
yield.
And if you plot the yields of those bonds, then the yield curve
would look something like this.
“The yield curve —
specifically, the spread between the interest rates on the ten-year
Treasury note and the three-month Treasury bill — is a
valuable forecasting tool. It is simple to use and significantly outperforms
other financial and macroeconomic indicators in predicting recessions two to six
quarters ahead.”
The slope of the yield
curve — the difference between the yields on short- and long-term maturity
bonds — has achieved some notoriety as a simple forecaster of economic growth. The
rule of thumb is that an inverted yield curve (short rates above long rates)
indicates a recession in about a year, and yield curve inversions have preceded
each of the last seven recessions. One of the recessions
predicted by the yield curve was the most recent one.”
In short, a yield curve inversion signals that a potential
recession may be coming in roughly a year’s time.
However, it’s worth pointing out that the Cleveland Fed also
noted that:
“There have been two
notable false positives: an inversion in late 1966 and a very flat curve in
late 1998.”
Did a yield curve inversion really happen?
Yes … there kinda was … technically speaking.
The yield of 5-year bonds moved below the yield of 2-year bonds
on December 3, which is the first inversion in a over a decade and naturally
made market players skittish.
Don’t get me wrong. That’s technically a yield curve inversion.
However, the yield curve inversion that the Fed
is keeping an eye on and that has heralded the last seven recessions is the one
between the “ten-year Treasury note and the
three-month Treasury bill“ as
the New York Fed puts it.
And as you see in the chart above, there’s
still a lot of distance to cover before the yield of 3-month bonds (purple
line) crosses over with the yield of 10-year bonds (green line).
Moreover, the chart below from the Cleveland Fed shows that the
last seven recessions (shaded areas) only happenedafter
the yield spread between 10-year and 3-month bonds turned negative by going
below that there dark, horizontal line. But as you can also
see, there’s presently still some ways to go before the yield spread turns
negative.
In summary, the yield curve inversion is used as a leading
indicator for recessions. And the market got jittery because of the
inversion between the yield of 5-year bonds and the yield of 2-year bonds,
which is the first inversion in over 10 years.
However, the best leading indicator for a potential recession
(even according to the Fed) is arguably the yield curve inversion of 3-month
and 10-year U.S. bonds. And based on the last seven recession, a recession only
occurs after the
yield spread turned negative.
And I just want to highlight once more that the Cleveland Fed
also noted that:
“There have been two
notable false positives: an inversion in late 1966 and a very flat curve in
late 1998.”
The correlation is therefore not absolute, which is why I
stressed that a yield curve inversion of 3-month and 10-year U.S. bonds is
only a leading indicator for a potential recession.
They are coming closer together, though, and the yield spread
has been steadily grinding towards the zero mark (and possibly below it), which
is a cause for concern.
And of course, we have to acknowledge that the market is driven
partly by emotions and a negative spread between 3-month and 10-year
bonds and a subsequent recession could become a self-fulfilling prophecy.
That does mean potentially higher volatility, though, so… Keep calm and enjoy the volatility!
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