It is said that while a massive fire consumed Rome in 64 A.D., Rome’s ruler, Nero, played his violin night and day. Since then the quote, “Rome burned while Nero fiddled,” has become a phrasing used when a palpable problem is ignored.
Currently, the bond market and the Federal Reserve are on fire, screaming at the top of their lungs that something is wrong. All the while, the stock market fiddles as if everything is normal. In this article, we explore the steep decline in bond yields to understand what is frightening bond traders.
The following graphs and tables will help you appreciate the message emanating from the bond markets.
The first graph below charts Eurodollar contract spreads which provide us with market expectations changes for the Fed Funds rate in the future.
Each Eurodollar contract represents a forward three month LIBOR rate for a specific three month period in the future. LIBOR, or the London Interbank Offer Rate, is the base rate that foreign banks lend to each other, corporations and other entities. For example, the current third Eurodollar contract represents the three -month LIBOR rate from mid-December of 2019 to mid-March of 2020. When various calendar Eurodollar rates are compared to each other the differences in yields provides us implied expectations for changes in the Fed Funds rate.
Data Courtesy Bloomberg
Currently, as shown with the blue line above, the difference between the third contract starting in mid-December is 18 basis points (0.18%) less than the first contract starting in mid-June. The difference tells us that the Eurodollar market currently expects three month LIBOR to decline 18 bps (0.18%) between June and December of 2019.
Since October of 2018, the three curves, spanning three different time frames (6, 9 and 21 months), have gone from a consensus expectation of approximately 0.50% of rate increases over the next two years to 0.18-0.56% of rate decreases over the same period. The 0.75% to 1.00% shift is remarkable over such a short period. Global traders, banks, and corporations that account for much of Eurodollar/LIBOR activity, influenced by fluid Fed outlook changes, have made sharp adjustments to their economic forecasts.
Yields and Yield Curves
The next chart shows the shift of the U.S. Treasury yield curve since January of 2018. The table below it provides further perspective for yield changes and curve gyrations. RIA Pro subscribers can better appreciate the shifting yield curve by reviewing the Latest Commentary from March 26, 2019. In that update, we provided an animated yield curve showing monthly yield curve movements since January 2018.
Data Courtesy Bloomberg
The graph below is based on an assessment of ten yield curves of varying time frames. As shown and labeled by the orange bar on the right side, half of them are currently inverted. Note that every time since the 1970’s that at least 50% of the curves were inverted a recession was soon to follow.
Data Courtesy Bloomberg
Negative Yielding Bonds
It is not just the Eurodollar and U.S. Treasury markets that think something is amiss. The final graph provides a global perspective on rates. Specifically, it plots the amount of negative yielding bonds worldwide. Again, the changes to economic outlooks and central bank policy that have occurred since last fall are not just related to the U.S. but are global.
Graph Courtesy Bloomberg
There is nothing normal with a negative yield, and we take notice when such a large number of bonds are trading below zero.
Bond markets around the world are worried that economic growth and inflation are slowing drastically. In the U.S., expectations have shifted from a Fed that would gradually raise rates through 2019 and 2020 and continue to reduce their balance sheet, to a Fed that is likely to cut rates over the next six to nine months and has announced the end of balance sheet reductions.
As illustrated in the table below, changes in Fed policy are a durable recession signal as the end of rate hike cycles are frequently followed by a downturn in the economy. If the Fed follows the market’s lead and puts an end to the hiking cycle that began in 2015, then we might very well be looking at a recession shortly.
Table Courtesy David Rosenberg at Gluskin Sheff
Fueling the bond markets are statements from past and present Fed Governors that are not only dovish but discuss a resumption of QE and negative interest rates. Former Fed Chairman, Janet Yellen, recently said the Fed needs more tools to battle a financial crisis. This is the same Janet Yellen that, in June of 2017, stated that she did not believe we would have a financial crisis in our lifetimes.
The Fed is sounding the alarms.
The bond market is burning.
The equity market is fiddling.
It is highly unlikely they are both right.