Views from Camelback

Inverted Yield Curve Nonsense

May 30, 2019

The yield curve is a financial concept that refers to a graph showing the amount of interest that U.S. Treasuries pay as a function of maturity.  A U.S. Treasury obligation is simply a loan between an investor and the U.S. government, which specifies that the investor gives money to the Treasury upfront in exchange for repayment plus a stated rate of interest between now and when the obligation matures.  If interest rates change over time, the value of a 1-month Treasury cannot be impacted too much because it will mature and turn into cash in 30 days.  In the case of a 30-year Treasury, an investor will be very happy to lock in a high rate if interest rates later decline.  Conversely, if someone buys a 30-year Treasury and rates go up, the investor will be disappointed, and this could last for 30 years.  Because longer-term bonds are more risky due to their potential price change as interest rates move up or down, they normally pay a higher rate of interest than short-term Treasuries.  Occasionally, longer-term Treasuries will actually pay a lower rate of interest than short-term Treasuries.  This is known as an inverted yield curve.  Historically, an inverted yield curve has been a reasonably good predictor of an impending recession in the next 6 to 18 months.

Financial markets pretty much worldwide did very poorly during the 4th quarter of 2018.  In the U.S., the Standard & Poor’s 500 declined by 13.5%.  Other global markets experienced similar declines or worse.  During the 4th quarter, markets became concerned that the Federal Reserve had raised rates too much and that this would trigger a recession.  Since many investors assumed we were going to have a recession, they also assumed demand for oil would decline and that pushed the price per barrel from a high of $76 in October 2018 to a price of $42 on Christmas Eve.  During the 4th quarter, markets priced in an impending recession. 

When 2019 arrived, the Federal Reserve changed their interest rate guidance dramatically to indicate that they were on hold for interest rate changes for the foreseeable future.  Specifically, they said they neither had a bias to raise rates nor lower rates.  The market took this to believe that the Fed would not raise rates in 2019 and perhaps they were done raising rates for this particular business cycle.  Some investors also began to price in a high probability of an interest rate decline later in 2019 or early 2020.  No one at the Fed suggested that a rate decline was likely anytime soon.

Financial markets have been very strong since the 1st of the year.  Here in the U.S., the S&P 500 hit a new all-time high on May 1st of 2,954 up approximately 17.8% since December 31, 2018.  Over the last 5 weeks, President Trump indicated that he thought the Chinese were stalling and reneging on past agreements in trade negotiations with the U.S.  This has upset the markets because the new tariffs that he has imposed and those that he is threatening to impose in the coming months could trigger a substantial slowdown in economic growth worldwide.  As investors have been selling stocks, the DOW is down about 7% from its high this year and the S&P 500 is down about 6%.  Investors have used the sales proceeds to buy U.S. Treasuries, pushing up the price and driving down the yield.  More importantly, European and Japanese investors have been borrowing money in Europe and Japan, converting the funds into U.S. dollars, and buying U.S. Treasuries.  This substantial excess demand from foreign investors has also pushed up the price of U.S. Treasuries, driving down the yield.  Some European countries actually have negative interest rates, in some cases stretching out to 10-year maturities.  The value of the dollar has increased as foreign investors have converted euros, pounds, and yen into dollars. 

The reason that an inverted yield curve has historically been a reasonably good predictor of an upcoming recession is that most recessions here in the U.S. have been caused by the Federal Reserve raising interest rates to cope with inflation and other market imbalances which has triggered economic weakness.  At this time, we see no evidence that the Fed has been raising interest rates to “choke off inflation”.  We also see little risk that this Federal Reserve will raise rates too much, thus causing a recession.  We believe that the low interest rates on a 10-year Treasury, currently 2.23% (compared to the 3-month Treasury currently 2.38%), is due primarily to excess demand for U.S. Treasuries from foreign investors.  If we are correct, the U.S. bond market is telling us absolutely nothing about the risk of an impending recession and is merely reacting to supply and demand for Treasuries driven in large part by foolish Central Bank policies in Europe and Japan.  If we are correct, this is a temporary market decline.  We will find out over the next several months as we hear from corporations about sales, profits, and future investment plans. 

The American consumer is alive and well, consumer confidence is at a 10-year high, and unemployment is at a 50-year low.  By most of the measures that we review, the U.S. economy is very healthy.  Financial markets today are filled with artificial intelligence, algorithms, hedge funds, and other short-term traders.  These “investors” are using their technology to look for patterns, such as an inverted yield curve, that will help them guess where the economy and the markets are going.  If their observation about the inverted yield curve is caused by a very different phenomenon and the economy is in-fact healthy, they will soon find the error of their ways and come back to buying stocks that they should not have sold in the first place.

As always, we will keep you posted as conditions develop.  We expect this decline may have a little further to go as the computers continue to upset each other about the impact of the inverted yield curve.

Please call any of us at L. Roy Papp & Associates if you would like to discuss this in further detail.

Best regards,

Harry Papp
Managing Partner
May 30, 2019