Amidst the headlines of the escalating trade battle, investors are piling into the safety of US treasury bonds. The increased appetite for bonds has pushed interest rates lower and caused the yield curve to invert. Historically, this has been an ominous sign for equity investors as an inverted yield curve has occurred prior to most recessions.
The yield on a 10-year treasury bond is watched closely by financial market participants. In general, if the yield rises, it is seen as a sign of economic strength. As investors see attractive opportunities outside the safety of risk-free bonds, they sell treasury bonds causing yields to rise. However, when investors expect the economy to slow in the future, they move more money back to the safety of bonds pushing interest rates lower. Remember, bond prices move in the opposite direction of interest rates.
Since the steep stock market correction late last year, stocks had gained roughly 25% through the end of April. One would expect that interest rates would have moved higher over that time. Instead, the yield on the 10-year treasury has fallen, suggesting that investors are increasingly worried about the future.
The chart below shows the divergence between the S&P 500 (blue) and the yield on a 10-year treasury bond (grey) over the last six months.
The big question now is, will the latest escalation of trade tensions lead to broader economic weakness? Maybe even a recession? At least for the moment, the bond market is suggesting that it will.
The Yield Curve & Future Returns for Stocks
The yield curve is the difference between short-term and long-term interest rates, and has a strong track record of inverting prior to a recession. An inverted yield curve is when long-term rates fall below short-term rates. Under normal economic conditions, long-term rates are higher than short-term rates. Since the yield curve is seen as a sign of a future recession, and a recession means falling stock prices, it is causing stocks to sell off now. Nobody wants to wait for the recession before adjusting their portfolio; by then it is too late.
The chart below shows the yield curve and the forward 12-month return for the stock market. Notice that shortly after the yield curve falling below zero (inverting), the returns for stocks over the following 12-months tends to decline sharply. Note, that the last time the yield curve inverted was prior to the 2008 financial crisis, and prior to that was in 2000 prior to the tech bubble.
However, what if a recession does not actually happen? Those who decide to sell stocks in favor of bonds will miss out if the stock market rebounds. An outcome that is likely if/when there is a trade agreement.
Making wholesale changes to your investment portfolio because of a single piece of data, in this case the yield curve, doesn’t make sense. That’s why our Business Cycle Indicator monitors an array of economic data to measure recession risks. Importantly, it is not yet warning of a recession.
Two Ways Out of This Mess
First, a trade agreement would go a long way for global trade and for financial markets. The world today is more intertwined than it has ever been. The trade dispute between the two largest economies has had ripple effects throughout the world. For example, economic data out of Germany has been terrible. Unfortunately, it looks like both sides are digging in their heels and negotiations have stalls.
At least for Trump, he does have a popularity contest to win in 2020. A prolonged trade war that leads to a recession and therefore a falling stock market, won’t bode well for his poll numbers. Even though you can count on him to point the blame on someone else. To be fair, there are a number of actors involved and no one person deserves all the blame. The likely scapegoat will be the Federal Reserve, which brings us to our second way out.
Rate Cuts by the Fed
The Federal Reserve controls the ebb and flow of the economy far more than most people realize. Their ability to raise or lower interest rates has a dramatic impact on economic growth. Since December of 2015, the Fed has been slowly raising interest rates as the economy improved. Earlier this year, they decided to pause future rate hikes as economic growth appeared to sputter at the end of 2018.
To offset the negative effects of US/China trade relations, the Fed could lower interest rates. This would stimulate the broader economy and make up for some of the weakness caused by tariffs. The market has been expecting the Fed to cut rates later this year. However, the minutes from the latest FOMC meeting showed that the Fed governors were not yet considering lowering rates. When the Fed doesn’t do what the market expects, volatility ensues.
The current level of the Federal Funds rate is 2.25% – 2.50%. The market expects 1 or 2 rate cuts by January of next year. One would expect the Fed to talk about the possibility of a rate cut before actually moving rates lower. The fact that they are not talking about it is causing concerns for the market.
Keep in mind, over the course of this now ten year old bull market, we have seen countless scary headlines. They cause sharp declines in the stock market, and cause investors to make irrational decisions with their investments. It is times like this that having a disciplined investment process will help investors stay the course, and ultimately lead to better results.