by Asset Allocation Committee

Interest rates have increased since early September.

The 10-year T-note yield dipped to 1.45% in early September but has risen strongly since then.  What has prompted this rise?  Some of the rise appears to be caused by a revaluation of the path of monetary policy.

The chart on the left shows the implied three-month LIBOR rate, two-years deferred, from the Eurodollar futures market.  After falling to a low near 1.15%, the yield has jumped to 1.58%.  The chart on the right shows this implied rate compared to the fed funds target.  Although the backup in the implied rate has reduced the expected decline in fed funds from nearly 100 bps to around 60 bps, the spread remains inverted, meaning the market still expects the Federal Reserve to cut rates somewhere between 50 bps and 75 bps over the next two years.

Our 10-year T-note model suggests that long-duration yields are too low, or prices on these instruments are too high.

This chart shows our 10-year T-note yield model.  The deviation line is at the one-standard error level.  Essentially, the bond market yield is consistent with recession.  If the bond market is right and a recession is coming, the chart above suggests that if that recession is a “garden-variety” type, like those seen in the 1990-91 and 2001 downturns, then it would be unlikely that we will see further yield declines.  On the other hand, when the model suggests long-dated Treasuries are overvalued and a recession doesn’t follow, the backup in yields is notable.  It’s still too early to tell if a recession is coming, but the evidence that one could develop is increasing.  Our analysis suggests, however, that the protection that long-duration Treasuries usually offer in a recession and bear market may not be all that significant at current yields.  If the above LIBOR analysis is correct, the recent backup in those yields would suggest a fed funds rate of around 1.50% and a fair value 10-year Treasury yield of 2.27%.  Thus, the recent backup in yields likely has further to run.

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by Asset Allocation Committee

In recent reports, we have discussed the yield curve and its value in signaling the business cycle.  One of the problems for investors with using the various permutations of the yield curve as a signaling device is that it gives such early warnings that it may not be all that useful.

This chart shows the total return for the S&P 500; the vertical lines denote the inversions of the yield curve.  The red lines represent when the inversion preceded a recession.  The black lines are inversions that resulted in false positives.[1]  The data shows that exiting equities at the point of inversion would, in several cases, be premature.  It might make sense to reduce equity exposure, but a complete retreat would not be warranted.

Labor market signals of recession tend to occur at or just before a downturn, but they also give us insight into when a recession may be imminent.  There are two indicators we like.  The first is the rolling 12-month sum of the monthly change in non-farm payrolls.  A reading of 1.5 million jobs is the indicator; falling below that level means a recession is near or underway.

The current reading is 2.074 mm, meaning payrolls remain in expansion mode.  The second indicator is the two-year change in the unemployment rate.

The current unemployment rate is 3.7%; in August 2017, it was 4.4%, meaning we still haven’t triggered a recession signal.  If the unemployment rate remains stable, we could be close to a recession signal in September 2020.

The labor market data suggests a recession isn’t imminent, meaning investors should avoid becoming overly defensive at this juncture.  That doesn’t mean one should not be watchful, but overreacting to the yield curve would be imprudent for most investors.

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[1] We are treating the current inversion as a false positive until proven otherwise.

by Asset Allocation Committee

In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions.  The indicator is constructed using commodity prices, initial claims and consumer confidence.  The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.  In this report, we will update the indicator with August data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the economy did slip late last year but has stabilized in 2019.  We have placed vertical lines at certain points when the indicator fell below zero.  It works fairly well as a signal that equities are turning lower, but there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or already underway and the equity markets have already begun their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at minus 1.0.  This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates.  At the same time, the fact that this variation of the indicator is just below zero raises caution.

What does the indicator say now?  The economy has decelerated but is not yet at a point where investors should become defensive.  Breaking below the red line would be our signal to expect a broader downturn.  As we have noted over the past two weeks, other indicators have signaled rising odds of recession.  We continue to monitor conditions closely but, as noted above, it is still too early to shift portfolios into a fully defensive stance.

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by Asset Allocation Committee

As various permutations of the yield curve invert, projections of recession are increasing.  One of our favorites, the 10-year T-note/fed funds yield curve, has been inverted for three months.

This chart shows the history of this yield curve; since 1960, every recession was preceded by an inversion of this indicator.  However, that isn’t to say that every inversion led to a recession. There were two false positives in the series, one in 1965 and another in 1998.  The former we consider a true false positive as the inversion lasted several months but a recession didn’t follow.  The latter event only lasted one month and was tied to the financial turmoil of the Asian Economic Crisis, the collapse of Long-Term Capital Management and the Russian debt default.  The fact that the inversion was short-lived weakens the case that it was a true inversion.

If this signal of recession holds, when does it arrive?  Here is a look at the timing:

On average, recessions occur 15 months after inversion; that would put the onset around next September.  The range is eight months to 18 months.  Using that range, the recession could begin as early as February 2020 or as late as February 2021.  Although this history offers some insight into timing, the reality is that the number of events is rather limited.  Thus, investors should treat the data as a guide.  The economic data remains mixed, but the preponderance of the evidence suggests that the U.S. economy is weakening but not in recession.

As we have noted before, recessions tend to have two causal factors, policy error and geopolitical events.  The 1973-75 and 1990-91 recessions are considered to be partly due to geopolitical factors; the former was affected by the Arab Oil Embargo and the latter by the Persian Gulf War.  However, both also had yield curve inversions.  It is quite possible that the geopolitical events caused the recessions to occur faster than they might have otherwise in the absence of these events.

We are watching the trade conflict with great interest because it might affect the timing of a downturn.  If the trade conflict worsens, lifting import prices and forcing the Fed to slow its path of lowering rates, the recession might occur sooner than it otherwise would.  A recession would certainly affect the 2020 elections; no incumbent has survived a recession since Calvin Coolidge.  We will likely begin to prepare for a downturn next year.  If the trade conflict worsens, the timing may be accelerated.

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