Tag Archives: Yield Curve

Special Report: Fed Launches A Bazooka As Markets Hit Our Line In The Sand

The severity of the recent market rout has been quite astonishing. As shown below, in just three very short weeks, the market has reversed almost the entirety of the “Trump Stock Market” gains.

The decline has been unrelenting, and despite the Fed cutting rates last week, and President Trump discussing fiscal stimulus, the markets haven’t responded. In mid-February we were discussing the markets being 3-standard deviations above their 200-dma which is a rarity. Three short weeks later, the markets are now 4-standard deviations below which is even a rarer event. 

On Wednesday, the Federal Reserve increased “Repo operations” to $175 Billion.

Still no response from the market

Then on Thursday, the Fed brought out their “big gun.”

The Fed Bazooka

Yesterday, the Federal Reserve stepped into financial markets for the second day in a row, this time dramatically ramping up asset purchases amid the turmoil created by the combination of the spreading coronavirus and the collapse in oil prices. 

In a statement from the New York Fed:

The Federal Reserve said it would inject more than $1.5 trillion of temporary liquidity into Wall Street on Thursday and Friday to prevent ominous trading conditions from creating a sharper economic contraction.

‘These changes are being made to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.’

The New York Fed said it would conduct three additional repo offerings worth an additional $1.5 trillion this week, with two separate $500 billion offerings that will last for three months and a third that will mature in one month.

If the transactions are fully subscribed, they would swell the central bank’s $4.2 trillion asset portfolio by more than 35%.” – WSJ

As Mish Shedlock noted,

“The Fed can label this however they want, but it’s another round of QE.”

As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.

Of course, this is what the market has been hoping for:

  • Rate cuts? Check
  • Liquidity? Check

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.

Special Report: Panic Sets In As “Everything Must Go”

Note: All charts now updated for this mornings open.

The following is a report we generate regularly for our RIAPRO Subscribers. You can try our service RISK-FREE for 30-Days.

Headlines from the past four-days:

Dow sinks 2,000 points in worst day since 2008, S&P 500 drops more than 7%

Dow rallies more than 1,100 points in a wild session, halves losses from Monday’s sell-off

Dow drops 1,400 points and tumbles into a bear market, down 20% from last month’s record close

Stocks extend losses following 15-minute ‘circuit breaker’ halt, S&P 500 drops 8%

It has, been a heck of a couple of weeks for the market with daily point swings running 1000, or more, points in either direction.

However, given Tuesday’s huge rally, it seemed as if the market’s recent rout might be over with the bulls set to take charge? Unfortunately, as with the two-previous 1000+ point rallies, the bulls couldn’t maintain their stand.

But with the markets having now triggered a 20% decline, ending the “bull market,” according to the media, is all “hope” now lost? Is the market now like an “Oriental Rug Factory” where “Everything Must Go?”

It certainly feels that way at the moment.

“Virus fears” have run amok with major sporting events playing to empty crowds, the Houston Live Stock Show & Rodeo was canceled, along with Coachella, and numerous conferences and conventions from Las Vegas to New York. If that wasn’t bad enough, Saudi Arabia thought they would start an “oil price” war just to make things interesting.

What is happening now, and what we have warned about for some time, is that markets needed to reprice valuations for a reduction in economic growth and earnings.

It has just been a much quicker, and brutal, event than even we anticipated.

The questions to answer now are:

  1. Are we going to get a bounce to sell into?
  2. Is the bear market officially started – from a change in trend basis; and,
  3. Just how bad could this get?

A Bounce Is Likely

In January, when we discussed taking profits out of our portfolios, we noted the markets were trading at 3-standard deviations above their 200-dma, which suggested a pullback, or correction, was likely.

Now, it is the same comment in reverse. The correction over the last couple of weeks has completely reversed the previous bullish exuberance into extreme pessimism. On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. Given that the oversold condition (top panel) is combined with a very deep “sell signal” in the bottom panel, it suggests a fairly vicious reflexive rally is likely. The question, of course, is how far could this rally go.

Looking at the chart above, it is possible we could see a rally back to the 38.2%, or the 50% retracement level is the most probable. However, with the severity of the break below the 200-dma, that level will be very formidable resistance going forward. A rally to that level will likely reverse much of the current oversold condition, and set the market up for a retest of the lows.

The deep deviation from the 200-dma also supports this idea of a stronger reflexive rally. If we rework the analysis a bit, the 3-standard deviation discussed previously has now reverted to 4-standard deviation move below the 200-dma. The market may find support there, and with the deeply oversold condition, it again suggests a rally is likely.

Given that rally could be sharp, it will be a good opportunity to reduce risk as the impact from the collapse in oil prices, and the shutdown of the global supply chain, has not been fully factored in as of yet.

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical black lines are buy periods)

The triggering of the “sell signals” suggests we are likely in a larger correction process. With the “bull trend” line now broken, a rally toward the 200-dma, which is coincident with the bull trend line, will likely be an area to take additional profits, and reduce risk accordingly.

The analysis becomes more concerning as we view other time frames.

Has A Bear Market Started?

On a weekly basis, the rising trend from the 2016 lows is clear. The market has NOW VIOLATED that trend, which suggests a “bear market” has indeed started. This means investors should consider maintaining increased cash allocations in portfolios currently. With the two longer-term sell signals, bottom panels, now triggered, it suggests that whatever rally may ensue short-term will likely most likely fail. (Also a classic sign of a bear market.)

With the market oversold on a weekly basis, a counter-trend, or “bear market” rally is likely. However, as stated, short-term rallies should be sold into, and portfolios hedged, until the correction process is complete.

With all of our longer-term weekly “sell signals” now triggered from fairly high levels, it suggests the current selloff is much like what we saw in 2015-2016. (Noted in the chart above as well.) In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in. If the market fails to hold current levels, the 2018 lows are the next most likely target.

Just How Bad Can It Get?

The idea of a lower bottom is also supported by the monthly data.

NOTE: Monthly Signals Are ONLY Valid At The End Of The Month.

On a monthly basis, sell signals have also been triggered, but we will have to wait until the end of the month for confirmation. However, given the depth of the decline, it would likely take a rally back to all-time highs to reverse those signals. This is a very high improbability.

Assuming the signals remain, there is an important message being sent, as noted in the top panel. The “negative divergence” of relative strength has only been seen prior to the start of the previous two bear markets, and the 2015-2016 slog. While the current sell-off resembles what we saw in late 2015, there is a risk of this developing into a recessionary bear market later this summer. The market is very close to violating the 4-year moving average, which is a “make or break” for the bull market trend from the 2009 lows.

How bad can the “bear market” get? If the 4-year moving average is violated, the 2018 lows become an initial target, which is roughly a 30% decline from the peak. However, the 2016 lows also become a reasonable probability if a “credit event” develops in the energy market which spreads across the financial complex. Such a decline would push markets down by almost 50% from the recent peak, and not unlike what we saw during the previous two recessions.

Caution is advised.

What We Are Thinking

Since January, we have been regularly discussing taking profits in positions, rebalancing portfolio risks, and, most recently, moving out of areas subject to slower economic growth, supply-chain shutdowns, and the collapse in energy prices. This led us to eliminate all holdings in international, emerging markets, small-cap, mid-cap, financials, transportation, industrials, materials, and energy markets. (RIAPRO Subscribers were notified real-time of changes to our portfolios.)

While there is “some truth” to the statement “that no one” could have seen the fallout of the “coronavirus” being escalated by an “oil price” war, there has been mounting risks for quite some time from valuations, to price deviations, and a complete disregard of risk by investors. While we have been discussing these issues with you, and making you aware of the risks, it was often deemed as “just being bearish” in the midst of a “bullish rally.” However, it is managing these types of risks, which is ultimately what clients pay advisors for.

It isn’t a perfect science. In times like these, it gets downright messy. But this is where working to preserve capital and limit drawdowns becomes most important. Not just from reducing the recovery time back to breakeven, but in also reducing the “psychological stress” which leads individuals to make poor investment decisions over time.

Given the extreme oversold and deviated measures of current market prices, we are looking for a reflexive rally that we can further reduce risk into, add hedges, and stabilize portfolios for the duration of the correction. When it is clear, the correction, or worse a bear market, is complete, we will reallocate capital back to equities at better risk/reward measures.

We highly suspect that we have seen the highs for the year. Most likely,,we are moving into an environment where portfolio management will be more tactical in nature, versus buying and holding. In other words, it is quite probable that “passive investing” will give way to “active management.”

Given we are longer-term investors, we like the companies we own from a fundamental perspective and will continue to take profits and resize positions as we adjust market exposure accordingly. The biggest challenge coming is what to do with our bond exposures now that rates have gotten so low OUTSIDE of a recession.

But that is an article for another day.

As we have often stated, “risk happens fast.”

Special Report: S&P 500 – Bounce Or Bull Market

Headlines from the past two days:

Dow sinks 2,000 points in worst day since 2008, S&P 500 drops more than 7%

Dow rallies more than 1,100 points in a wild session, halves losses from Monday’s sell-off

Actually its been a heck of a couple of weeks for the market with daily point swings running 1000, or more, points in either direction.

However, given Tuesday’s huge rally, is the market’s recent rout over with the bulls set to take charge? Or is this just a reflexive rally, with a retest of lows set to come?

Let’s take a look at charts to see what we can determine.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. Given that the oversold condition (top panel) is combined with a very deep “sell signal” in the bottom panel, it suggested a fairly vicious reflexive rally was likely. The question, of course is how far could this rally go.

Looking at the chart above, it is quite possible we could well see a rally back to the 32.8%, or even the 50% retracement level which is where the 200-dma currently resides. A rally to that level will likely reverse much of the current oversold condition and set the market up for a retest of the lows.

This idea of a stronger reflexive rally is also supported by the deep deviation from the 200-dma. If we rework the analysis a bit, the 3-standard deviation discussed previously has now reverted to 2-standard deviations below the 200-dma. The market found support there, and with the deep oversold condition it again suggests a rally to the 200-dma is likely.

Given that rally could be sharp, it will likely be a good opportunity to reduce risk as the impact from the collapse in oil prices and the shutdown of the global supply chain has not been fully factored in as of yet.

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical black lines are buy periods)

The triggering of the “sell signals” suggests we are likely in a larger correction process. With the “bull trend” line now broken, a rally back to toward the 200-dma, which is coincident with the bull trend line, will likely be an area to take profits and reduce risk accordingly.

The analysis becomes more concerning as we view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has NOW VIOLATED that trend, which suggests maintaining some allocation to cash in portfolios currently. With the two longer-term sell signals, bottom panels, now triggered, it suggests that whatever rally may ensue short-term will likely fail.

The market is getting oversold on a weekly basis which does suggest a counter-trend rally is likely. However, as stated, short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

With all of our longer-term weekly “sell signals” now triggered from fairly high levels, it suggests the current selloff is much like what we saw in 2015-2016. (Noted in chart above as well.) In other words, we will see a rally, a failure to lower lows, before the ultimate bottom is put in.

Monthly

The idea of a lower bottom is also supported by the monthly data.

On a monthly basis, sell signals have also been triggered. HOWEVER, these signals must remain through the end of the month to be valid. These monthly signals are “important,” and one of the biggest concerns, as noted in the top panel, is the “negative divergence” of relative strength which was only seen prior to the start of the previous two bear markets, and the 2015-2016 slog. Again, the current sell-off resembles what we saw in late 2015, but there is a risk of this developing into a recessionary bear market later this summer. Caution is advised.

What We Are Thinking

Since January we have been taking profits in positions, rebalancing portfolio risks, and recently moving out of areas subject to slower economic growth, a supply-chain shut down, and the collapse in energy prices. (We have no holdings in international, emerging markets, small-cap, mid-cap, financial or energy currently.)

We are looking for a rally that can hold for more than one day to add some trading exposure for a move back to initial resistance levels where we will once again remove those trades and add short-hedges to the portfolio.

We highly suspect that we have seen the highs for the year, so we will likely move more into a trading environment in portfolios to add some returns while we maintain our longer-term holdings and hedges.

Given we are longer-term investors, we like the companies we own from a fundamental perspective and will continue to take profits and resize positions as we adjust market exposure accordingly. The biggest challenge coming is what to do with our bond exposures now that rates have gotten so low OUTSIDE of a recession.

We will keep you updated accordingly.

Special Report: S&P 500 Plunges On Coronavirus Impact

Dow plunges 1,000 points on coronavirus fears, 3.5% drop is worst in two years

“Stocks fell sharply on Monday as the number of coronavirus cases outside China surged, stoking fears of a prolonged global economic slowdown from the virus spreading. – CNBC

According to CNBC’s logic, the economy was perfectly fine on Friday, even though the market sold off then as well. However, over the weekend, stocks are plunging because the virus is now important?

No, this has been a correction in the making for the past several weeks that we have been discussing in our weekly market updates. Here was what we posted yesterday morning:

  • As noted last week: “With the market now trading 12% above its 200-dma, and well into 3-standard deviations of the mean, a correction is coming.” That correction started last Friday.
  • Currently, there is a strong bias to “buy the dip” of every corrective action. We recognize this and given the S&P 500 hit initial support on Friday we did add 1/2 position of VOOG to the Dynamic Model. The model is underallocated to equities and has a short hedge so we are taking this opportunity to add slowly. However, we suspect there is more to this corrective action to come this week.
  • As noted previously, extensions to this degree rarely last long without a correction. There is more work to be done before the overbought and extended condition is corrected. We will look to add to our holdings during that process.

While the correction occurred all in one day, which wasn’t our preference, it nonetheless set the markets up for a short-term bounce. We highly suggest using that bounce to rebalance portfolio risks accordingly.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we rework the analysis a bit, the 3-standard deviation discussed previously is in the correction process. However, with the break of the 50-dma, uptrend channel, and triggering a short-term sell signal, the 200-dma comes into focus as important support.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk.

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical black lines are buy periods)

Notice that while the market has been rising since early 2016, the momentum indicators are extremely stretched. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is denoted by the trend channel. At this juncture, the market has not violated any major support points and does not currently warrant a drastically lower exposure to risk. However, if the “sell signals” are triggered, it will suggest a larger “reduction” of risk.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are closing. If they both confirm, it will suggest a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the bulls remain in control currently, which keeps our portfolios primarily allocated to equity risk. As we have noted previously, the market had triggered a “buy” signal in October of last year as the Fed “repo” operations went into overdrive. These monthly signals are “important,” but it won’t take a tremendous decline to reverse those signals. It’s okay to remain optimistic short-term, just don’t be complacent.

Don’t Panic Sell

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the months ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio, and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 58.2% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  2. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  3. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tends to lead when markets fall. Like “weeds choking a garden,” pull them.
  4. Add to sectors, or positions, that are performing with, or outperforming the broader market.
  5. Move “stop-loss” levels up to current breakout levels for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
  6. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  7. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

While we remain optimistic about the markets currently, we are also taking precautionary steps of tightening up stops, adding non-correlated assets, raising some cash, and looking to hedge risk opportunistically.

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

Non-QE QE and How to Trade It

“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.” He then stated: “In no sense is this QE.” –Federal Reserve Chairman Jerome Powell 10/8/2019

Jerome Powell can call balance sheet growth whatever he wants, but operationally and in its effect on the bond markets, it is QE. For more on the Fed’s latest iteration of QE, what we dub the non-QE QE, please read our article QE By Any Other Name.

Non-QE = QE4

It is increasingly likely the Fed will announce an asset purchase operation at the FOMC meeting on October 30, 2019. Given Powell’s comments, the asset purchases will differ somewhat from QE 1, 2, and 3 in that the Fed will add needed reserves to the banking system to help alleviate recent bouts of stress in overnight funding markets. Prior versions of QE added excess reserves to the system as a byproduct. The true benefit of prior rounds of QE was the reduction of Treasury and mortgage-backed securities in the marketplace, which pushed investors into riskier stocks and bonds.  

Since the Feds motivation seems to be stress in the short term funding markets, we believe the Fed will purchase short-term notes and Treasury bills instead of longer-term bonds. QE1 also involved the purchase the short term securities, but these securities were later sold and the proceeds used to purchase longer term bonds, in what was called Operation Twist.

Trading Non QE QE4

In Profiting From a Steepening Yield Curve and in a subsequent update to the article, we presented two high dividend stocks (AGNC and NLY) that should benefit from a steeper yield curve. When we wrote the articles, we did not anticipate another round of QE, at least not this soon. Our premise behind these investments was weakening economic growth, the likelihood the Fed would cut rates aggressively, and thus a steepening yield curve as a result.

The Fed has since cut rates twice, and Wall Street expects them to cut another 25bps at the October 30th meeting and more in future meetings. This new round of proposed QE further bolsters our confidence in this trade.

If the Fed purchases shorter-term securities, the removal of at least $200 to $300 billion, as is being touted in the media, should push the front end of the curve lower in yield. Short end-based QE in conjunction with the Fed cutting rates will most certainly reduce front-end yields. The rate cuts combined with QE will likely prevent long term yields from falling as much as they would have otherwise. On balance, we expect the combination of QE and further rate cuts to result in a steeper yield curve.

The following graph shows how the 10yr/2yr Treasury yield curve steepened sharply after all three rounds of QE were initiated. In prior QE episodes, the yield curve steepened by 112 basis points on average to its peak steepness in each episode.  

Data Courtesy: Federal Reserve

New Trade Idea

In addition to our current holdings (AGNC/NLY), we have a new recommendation involving a long/short bond ETF strategy. The correlation of performance and shape of the yield curve of this trade will likely be similar to the AGNC/NLY trade, but it should exhibit less volatility.

Equity long/short trades typically involve equal dollar purchases and sales of the respective securities, although sometimes they are also weighted by beta or volatility. Yield curve trades are similar in that they should be dollar-weighted, but they must also be weighted for the bond’s respective durations to account for volatility. This is because the price change of a two-year note is different than that of a 5 or 10-year note for the same change in yield, a concept called duration. Failing to properly duration weight a yield curve trade will not provide the expected gains and losses for given changes in the shape of the yield curve. 

Before presenting the trade, it is important to note that the purest way to trade the yield curve is with Treasury bonds or Treasury bond futures. Once derivative instruments, like the ETFs we discuss, are introduced, other factors such as fees, dividends, and ETF rebalancing will affect performance.  

The duration for SHY and IEF is 2.17 and 7.63, respectively. The ratio of the price of SHY to IEF is .74. The trade ratio of SHY shares to IEF shares is accordingly 4.75 as follows: [(1/.74)*(7.63/2.17)]. As such one who wishes to follow our guidance should buy 5 shares for every 1 share of IEF that they short.

Because we cannot buy fractions of shares, we rounded up the ratio to 5:1. This slight overweighting of SHY reflects our confidence that the short end of the yield curve will fall as the Fed operates as we expect.

Summary

In Investors Are Grossly Underestimating the Fed, we highlighted that every time the Fed has raised and lowered rates, the market has underestimated their actions. To wit:

“If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.”

Despite the Fed’s guidance earlier this year of one or two cuts and their characterization of it as a “mid-cycle adjustment”, the Fed has already lowered rates twice and appears ready to cut rates a third time later this month. If, in fact, the market is once again underestimating the Fed, the Fed Funds rate and short term Treasury yields will ultimately fall to 1% or lower.

In an environment of QE and the Fed actively lowering rates, we suspect the yield curve will steepen. That is in no small part their objective, as a steeper yield curve also provides much needed aid to their constituents, the banks. If we are correct that the curve steepens, the long-short trade discussed above along with AGNC and NLY should perform admirably.  AGNC and NLY are much more volatile than IEF and SHY; as such, this new recommendation is for more risk-averse traders.  

UPDATE: Profiting From A Steepening Yield Curve

In June we wrote an RIA Pro article entitled Profiting From A Steepening Yield Curve, in which we discussed the opportunity to profit from a steepening yield curve with specific investments in mortgage REITs. We backed up our words by purchasing AGNC, NLY, and REM for RIA Advisor clients. The same trades were shared with RIA Pro subscribers and can be viewed in the RIA Pro Portfolios under the Portfolio tab.

We knew when we published the article and placed the trades that the short term risk to our investment thesis was, and still is, a further flattening and even an inversion of the yield curve. That is precisely what happened. In mid to late August the curve inverted by four basis points but has since widened back out.

The graph below compares the 2s/10s yield curve (blue) with AGNC (orange) and NLY (green). Beneath the graph is two smaller graphs showing the rolling 20-day correlation between AGNC and NLY versus the yield curve.

Since writing the article and purchasing the shares, the securities have fallen by about 5%, although much of the price loss is offset by double digit dividends (AGNC 13.20%, NLY 10.73%, and REM 9.06%). While we are not happy with even a small loss, we are emboldened by the strong correlation between the share prices and the yield curve. The trade is largely a yield curve bet, so it is comforting to see the securities tracking the yield curve so closely.

We still think the yield curve will steepen significantly. In our opinion, this will likely occur as slowing growth will prompt the Fed to be more aggressive than their current posture. We also think that there is a high probability that when the Fed decides to become more aggressive they will reduce rates at a faster clip than the market thinks. As we discussed in Investors Are Grossly Underestimating the Fed, when the Fed is actively raising or reducing rates, the market underestimates that path.

To wit:  If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?”

Bolstering our view for a steeper yield curve is that the Fed, first and foremost, is concerned with the financial health of its member banks. The Fed will fight an inverted yield curve because it hurts banks profit margins and therefore reduces their ability to lend money. Because of this and regardless of the economic climate, the Fed will use words and monetary policy actions to promote a steeper yield curve.

We are very comfortable with the premise behind our trades, and in fact in mid-August we doubled our position in AGNC. We will also likely add to NLY soon.

For more on this investment thesis, please watch the following Real Vision interview Steepening Yield Curve Could Yield Generational Opportunities.

What is Bill Dudley Thinking?

On August 27, 2019, Bill Dudley, former Chief Economist for Goldman Sachs and President of the Federal Reserve Bank of New York from 2009-2018, published a stunning editorial in Bloomberg (LINK). After reading the article numerous times, there are a few noteworthy observations worth discussing.

Dudley’s Myopic View

Before we dissect Bill Dudley’s opinions and try to understand his motivations, consider the article’s subtitle- “The central bank should refuse to play along with an economic disaster in the making.”

There is little doubt that Trump’s hard stance on trade and the seemingly impetuous use of tariffs and harsh Twitter commentary presents new challenges for economic growth. Global trade has slowed and manufacturers are retrenching to limit their risks.

Whether the trade war is or will be an “economic disaster” as Dudley says, is up for debate. What is remarkable about this comment is the lack of understanding of the economic instability prior to the trade war and how it got to that point.   

As we have discussed on numerous occasions, the Fed has used excessive monetary policy over the last decade to promote economic growth. Dudley and the Fed fail to recognize that their actions have led to rampant speculation in the financial markets, encouraged significant uses of debt for nonproductive purposes, and have fueled the wealth and income divergences. More concerning, their actions have reduced the natural economic growth rate of the country for years and possibly decades to come. Dudley and colleagues arranged the tinder for what will inevitably be an economic disaster. Trump may or may not be the spark.

Dudley sets up his article with a leading question-“This manufactured disaster-in-the-making presents the Federal Reserve with a dilemma: Should it mitigate the damage by providing offsetting stimulus, or refuse to play along?”

He answers, in part, by saying that, based on the Fed’s obligations and “conventional wisdom”, the Fed should respond to economic weakness due to the trade war by “adjusting monetary policy accordingly.” Historically, the Fed has changed policy to counter outside, non-economic factors.

Dudley, however, takes a different tack and asks if easier Fed policy would encourage “the President to escalate the trade war further.” This is where the editorial gets political. He goes on to state his case for the Fed taking a hard line and not adjust monetary policy if the trade war negatively affects economic activity. Dudley believes that by doing nothing, the Fed would:

  • Discourage further trade war escalation
  • Reinforce the Fed’s independence
  • Preserve much needed “ammunition”, as there is little room to cut rates

In the next paragraph, he stresses Trump’s attacks on Chairman Powell and provides more reasoning for the Fed to leave policy alone. Dudley believes the Fed, by not adjusting monetary policy to offset the effects of the trade war in progress, would send a clear signal to the President that he bears the risks of a recession and losing an election. The Fed, thereby, would not be complicit.  

Before going on, we think it’s appropriate to re-emphasize that the next recession will be amplified due to Fed actions over the last ten years. Bernanke should never have extended extraordinary measures beyond the first round of quantitative easing, and Janet Yellen had ample opportunities to raise interest rates and reduce the Fed’s balance sheet during her tenure. Trying to place all of the blame on the current President, or anyone else for that matter, may work in the media and even the populace but it does not line up with the facts.

Dudley’s Summary

Dudley concludes with a stunning and politically motivated statement- “There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”   

Dudley is essentially imploring Powell to base monetary policy on the coming election. If Fed independence is what Dudley cherishes, he certainly did not do the Fed any favors. This implicates elites like Dudley, one of the “Davos Men,” who think they know better than the collective decisions of people engaged in free-market exchanges. It also makes him guilty of an effort to manipulate an election.

Summary

Here is an important question. Is this editorial solely Dudley’s thoughts, or was Jerome Powell and the Fed involved in any way?  The Fed has already come out against the article, but in Washington, nothing is ever that clear cut.

If the editorial was in some way subsidized or suggested by Powell, the implications of the Fed going after the President will call into question their independence in the future. No matter how deeply improper that is, it certainly leaves open the question of whether or not people are justified in those efforts. In the same way that no Fed official should ever be viewed as complicit, no President should impose his will from the bully pulpit of the Presidency to influence monetary policy.

From an investment perspective, this is not good. The markets have benefited from a Fed that has promoted asset price inflation and sought to convince us that the economic cycle is dead. Despite sky-high valuations, investors tend to believe that these valuations are fair and that the Fed will always be there as a reliable safety net.

We do not know how this saga will end, but we do know that if confidence in the Fed is compromised, investors will likely vote with their feet.

Caroline’s Summary

We leave you with some thoughts on the subject from Caroline Baum of MarketWatch:

“It is hard to fathom what Dudley was thinking in advocating such an off-the-wall idea of factoring political outcomes into policy decisions. The Fed has a dual mandate from Congress to promote maximum employment and price stability. There is nothing in that mandate, or in the Federal Reserve Act, about influencing election outcomes. Nothing in there either about being part of “the Resistance” to this president.

That would be a dangerous expansion of Federal Reserve’s operating framework.”

The Mechanics of Absurdity

Over the past few decades, the central banks, including the Federal Reserve (Fed), have relied increasingly on interest rates to help modify economic growth. Interest rate management is their tool of choice because it can be effective and because central banks regulate the supply of money, which directly effects the cost to borrow it. Lower interest rates incentivize borrowers to take on debt and consume while dis-incentivizing savings.

Regrettably, a growing consequence of favoring lower than normal interest rates for prolonged periods is that consumers, companies, and nations grow increasingly indebted as a percentage of their respective income. In many cases, consumption is pulled from the future to the present day. Accordingly, less consumption is needed in the future and a larger portion of income and wealth must be devoted to servicing the accumulated debt as opposed to productive ventures which would otherwise generate income to help pay off the debt.

Today, interest rates are at historically low levels around the globe. Interest rates are negative in Japan and throughout much of Europe. In this article, we expound on the themes laid out in Negative is the New Subprime, to discuss the mechanics of negative-yielding debt as well as the current mindset of investors that invest in negative-yielding debt.

Is invest the right word in describing an asset that when held to maturity guarantees a loss of capital?

Negative Yield Mechanics

Negative yields are not only bestowed upon sovereign debt, as investment grade and even some junk-rated debt in Europe now carry negative yields. Even stranger, Market Watch just wrote about a Danish bank offering consumers’ negative interest rate mortgages (LINK).

You might be thinking, “Wow, I can take out a negative interest rate loan, receive payments every month or quarter and then pay back what was lent to me?” That is not how it works, at least not yet. Below are two examples that walk through the lender and borrower cash flows for negative-yielding debt.

Some of the bonds trading at negative yields were issued when yields were positive and therefore have coupon payments. For example, in August of 2018, Germany issued a 30 year bond with a coupon of 1.25%. The price of the bond is currently $143, making the yield to maturity -0.19%. Today, it will cost you $14,300 to buy $10,000 face value of the bond. Going forward, you will receive coupon payments of $125 a year and ultimately receive $10,000 in 2048. Over the next 29 years you will receive $3,625 in coupon payments but lose $4,300 in principal, hence the current negative yield to maturity.

Bonds issued with a zero coupon with negative yields are similar in concept but the mechanics are slightly different than our positive coupon example from above. Germany issued a ten-year bond which pays no coupon. Currently, the price is 106.76, meaning it will cost an investor $10,676 to buy $10,000 face value of the bond. Over the next ten years the investor will receive no coupon payments, and at the end of the term they will receive $10,000, resulting in a $676 loss. The lower the negative yield to maturity, the higher premium to par and the greater loss of principal at maturity.

We suspect that example two, the zero-coupon bond issued at a price above par, will be the issuance model going forward for negative yielding bonds.

Why?

At this point, after reviewing the cash flows on the German bonds, you are probably asking why an investor would make an investment in which they are almost guaranteed to lose money. There are two predominant reasons worth exploring.

Safety: Investors that store physical gold in a gold vault pay a fee for safe storage. Individuals with expensive jewelry or other keepsakes pay banks a fee to use their vaults. Custodians, such as Fidelity or Schwab, are paid fees for the safekeeping of our stocks and bonds.

Storing money, as a deposit in a bank, is a little different from the prior examples. While banks are a safer place to store money than a personal vault, mattress, or wallet, the fact is that deposits are loans to the bank. Banks traditionally pay depositors an interest rate so that they have funds they can lend to borrowers at higher rates than the rate incurred on the deposit.

With rates negative in Europe and Japan, their respective central banks have essentially made the storing of deposits with banks akin to the storage of gold, jewelry, and stocks – they are subject to a safe storage fee.  Unfortunately, many people and corporations have no choice but to store their money in negative-yielding instruments and must lend money to a bank and pay a “storage fee.”  

On a real return basis, in other words adjusted for inflation, whether an investor comes out ahead by lending in a negative interest rate environment, depends on changes to the cost of living during that time frame. Negative yielding bonds emphatically signal that Germany will be in a deflationary state over the next ten years. With global central bankers taking every possible step, legal and otherwise, to avoid deflation and generate inflation, betting on deflation via negative yielding instruments seems like a poor choice for investors.

Greater Fool Theory: Buying a zero-coupon bond for 101 today with the promise of receiving 100 is a bad investment. Period. Buying the same bond for 101 today and selling it for 102 tomorrow is a great investment. As yields continue to fall further into negative territory, the prices of bonds rise. While the buyer of a negative-yielding bond may not receive a coupon, they can still profit, and sometimes appreciably as yields decline.

This type of trade mindset falls under the greater fool theory. Per Wikipedia:

“In finance and economics, the greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems “foolishly” high because one may rationally have the expectation that the item can be resold to a “greater fool” later.”

More succinctly, someone buying a bond that guarantees a loss can profit if they can find someone even more willing to lose money.

Scenario Analysis

Let’s now do a little scenario analysis to understand the value proposition of holding a negative-yielding bond.

For all three examples we use a one year bond to keep the math simple. The hypothetical bond details are as follows:

  • Issue Date: 9/1/2019
  • Maturity Date: 9/1/2020
  • Coupon = 0%
  • Yield at Issuance: -1.0%
  • Price at Issuance: 101.00

Greater fool scenario: In this scenario, the bondholder buys the new issue bond at 101 and sells it a week later at 101.50. In this case, the investor makes a .495% return or almost 29% annualized.

Normalization: This next scenario assumes that yields return to somewhat normal levels and the holder sells the bond in six months.If the yield returns to zero in six months, the price of the bond would fall to 100. In this case, our investor, having paid 101.00, will lose 1% over the six month period or 2% annualized.

Hold to maturity: If the bond is held to maturity, the bondholder will be redeemed at par losing 1% as they are paid $100 at maturity on a bond they purchased for $101.

Summary

Writing and thinking about the absurdity of negative yields is taxing and unnatural. It forces us to contemplate basic financial concepts in ways that defy common sense and rational thought. This is not a pedantic white paper discussing hypothetical central bank magic tricks and sleight of hand; this is about something occurring in real-time.

Excessive monetary policy has been the crutch of growth for decades spurred by an intense desire to avoid and minimize otherwise healthy and routine economic corrections. It was fueled by the cult of personality which took over in the 1990s when Alan Greenspan was labeled “The Maestro”. He, Robert Rubin, and Lawrence Summers were christened “The Committee to Save the World” by Time magazine in February 1999.  Greenspan was then the subject of a biography by famed Watergate journalist Bob Woodward infamously titled Maestro in 2000.

Under Greenspan and then Bernanke, Yellen and now Powell, rational monetary policy and acknowledgement of naturally occurring business cycles has taken a back seat to avoidance of these economic cycles at all cost. As a result, central bankers around the world are trying justify the inane logic of negative rates.

Comparing Yield Curves

Since August of 1978, there have been seven instances where the yields on ten-year Treasury Notes were lower than those on two-year Treasury Notes, commonly referred to as “yield curve inversion.” That count includes the current episode which only just occurred. In all six prior instances a recession followed, although in some cases with a lag of up to two years.

Given the yield curve’s impeccable 30+ year track record of signaling recessions, we think it is appropriate to compare the current inversion to those of the past. In doing so, we can further refine our economic and market expectations.

Bull or Bear Flattening

In this section, we graph the seven yield curve inversions since 1978, showing how ten-year U.S. Treasuries (UST), two-year UST and the 10-year/2 year curve performed in the year before the inversion.

Before progressing, it is worth defining some bond trading lingo:

  • Steepener- Describes a situation in which the difference between the yield on the 10-year UST and the yield on the 2y-year UST is increasing. Steepeners can occur when both securities are trending up or down in yield or when the 2-year yield declines while the 10-year yield increases.
  • Flattener- A flattener is the opposite of a steepener, and the difference between yields is declining.  As shown in the graph above, the slope of the curve has been in a flattening trend for the last five years.
  • Bullish/Bearish- The terms steepener and flattener are typically preceded with the descriptor bullish or bearish. Bullish means yields are declining (bond prices are rising) while bearish means yields are rising (bond prices are falling). For instance, a bullish flattener means that both 2s and 10s are declining in yield but 10s are declining at a quicker pace. A bearish flattener implies that yields for 2s and 10s are rising with 2s increasing at a faster pace.  Currently, we are witnessing a bullish flattener. All inversions, by definition, are preceded by a flattening trend.

As shown in the seven graphs below, there are two distinct patterns, bullish flatteners and bearish flatteners, which emerged before each of the last seven inversions. The red arrows highlight the general trend of yields during the year leading up to the curve inversion.  

Data for all graphs courtesy St. Louis Federal Reserve

Five of the seven instances exhibited a bearish flattening before inversion. In other words, yields rose for both two and ten year Treasuries and two year yields were rising more than tens. The exceptions are 1998 and the current period. These two instances were/are bullish flatteners.

Bearish Flattener

As the amount of debt outstanding outpaces growth in the economy, the reliance on debt and the level of interest rates becomes a larger factor driving economic activity and monetary and fiscal policy decisions. In five of the seven instances graphed, interest rates rose as economic growth accelerated and consumer prices perked up. While the seven periods are different in many ways, higher interest rates were a key factor leading to recession. Higher interest rates reduce the incentive to borrow, ultimately slowing growth and in these cases resulted in a recession.

Bullish Insurance Flattener

As noted, the current period and 1998 are different from the other periods shown. Today, as in 1998, yields are falling as the 10-year Treasury yield drops faster than the 2-year Treasury yield. The curve thus flattens and ultimately inverts.

Seven years into the economic expansion, during the fall of 1998, the Fed cut rates in three 25 basis point increments. Deemed “insurance cuts,” the purpose was to counteract concerns about sluggish growth overseas and financial market concerns stemming from the Asian crisis, Russian default, and the failure of hedge fund giant Long Term Capital. The yield curve inversion was another factor driving the Fed. The domestic economy during the period was strong, with real GDP staying above 4%, well above the natural growth rate.  

The current period is somewhat similar. The U.S. economy, while not nearly as strong as the ’98 experience, has registered above-trend economic growth for the last two years. Also similar to 1998, there are exogenous factors that are concerning for the Fed. At the top of the list are the trade war and sharply slowing economic activity in Europe and China. Like in 1998, we can add the newly inverted yield curve to the list.

The Fed reduced rates by 25 basis points on July 31, 2019. Chairman Powell characterized the cut as a “mid-cycle adjustment” designed to ensure solid economic growth and support the record-long expansion. Some Fed members are describing the cuts as an insurance measure, similar to the language employed in 1998.

If 1998-like “insurance” measures are the Fed’s game plan to counteract recessionary pressures, we must ask if the periods are similar enough to ascertain what may happen this time.

A key differentiating factor between today and the late 1990s is not only the amount of debt but the dependence on it.   Over the last 20 years, the amount of total debt as a ratio to GDP increased from 2.5x to over 3.5x.

Data Courtesy St. Louis Federal Reserve

In 1998, believe it or not, the U.S. government ran a fiscal surplus and Treasury debt issuance was declining. Today, the reliance on debt for new economic activity and the burden of servicing old debt has never been greater in the United States. Because rates are already at or near 300-year lows, unlike 1998, the marginal benefits from borrowing and spending as a result of lower rates are much less economically significant currently.

In 1998, the internet was in its infancy and its productive benefits were just being discovered. Productivity, an essential element for economic growth, was booming. By comparison, current productivity growth has been lifeless for well over the last decade.

Demographics, the other key factor driving economic activity, was also a significant component of economic growth. Twenty years ago, the baby boomers were in their spending and investing prime. Today they are retiring at a rate of 10,000 per day, reducing their consumption and drawing down their investment accounts.

The key point is that lower rates are far less likely to spur economic activity today than in 1998. Additionally, the natural rate of economic growth is lower today, so the economy is more susceptible to recession given a smaller decline in economic activity than it was in 1998.

The 1998 rate cuts led to an explosion of speculative behavior primarily in the tech sectors. From October of 1998 when the Fed first cut rates, to the market peak in March of 2000, the NASDAQ index rose over 300%. Many equity valuation ratios from the period set records.

We have witnessed a similar but broader-based speculative fervor over the last five years. Valuations in some cases have exceeded those of the late 1990s and in other cases stand right below them. While the economic, productivity, and demographic backdrops are not the same, we cannot rule out that Fed cuts might fuel another explosive rally. If this were to occur, it will further reduce expected returns and could lead to a crushing decline in the years following as occurred in the early 2000s.  

Summary

A yield curve inversion is the bond market’s way of telegraphing concern that economic growth will slow in the coming months. Markets do not offer guarantees, but the 2s-10s yield curve has been right every time in the last 30 years it voiced this concern. As the book of Ecclesiastes reminds us, “the race does not always go to the swift nor the battle to the strong…”, but that’s the way to bet.

Insurance rate cuts may buy the record-long economic expansion another year or two as they did 20 years ago, but the marginal benefit of lower rates is not nearly as powerful today as it was in 1998.

Whether the Fed combats a recession in the months ahead as the bond market warns or in a couple of years, they are very limited in their abilities. In 2000 and 2001, the Fed cut rates by a total of 575 basis points, leaving the Fed Funds rate at 1.00%. This time around, the Fed can only cut rates by 225 basis points until it reaches zero percent. When we reach that point, and historical precedence argues it will be quicker than many assume, we must then ask how negative rates, QE, or both will affect the economy and markets. For this there is no prescriptive answer.

The Dog Whistle Heard Around The World

On August 15, 2019 the Washington Post led with a story entitled Markets sink on recession signal. The recession signal the Post refers to is the U.S. Treasury yield curve which had just inverted for the first time in over ten years.

We have been highlighting the flattening yield curve for the past six months. As we have discussed, every time the ten-year Treasury yield has fallen below the two-year Treasury yield, thus inverting the yield curve, a recession has eventually developed.

Blaming the yield curve for market losses because it inverted by a couple of basis points is a nonsensical narrative for talking heads on business television. This article is about a different concern, a second-order effect caused by headlines like the one shown below. The story in the Post and similar ones in many major publications have awoken the public to the real possibility that a recession may be coming. It is a dog whistle that may cause the public to alter their behavior, and even slight changes in consumption habits can produce outsized effects on economic activity.

Reality

The 2s/10s yield curve stood at 265 basis points on January 1, 2014, meaning the ten-year yield was 2.65% higher than the two-year yield. From that date forward, as shown below, it has steadily declined. Like the changing of the seasons, as the days passed, that spread steadily fell. Unlike the seasons, investors are somehow now suddenly shocked to learn that economic winter follows fall.  Since the beginning of 2019, the curve has been as steep as 25 basis points but has flirted with inversion on numerous occasions.

Given that the shape of the yield curve has been steadily flattening for five years, its current inversion ought not to be news. From an economic perspective, who cares, nothing has changed. The difference in a few basis points on the yield curve is truly meaningless. What has changed is investors’ behavioral instincts.

Explanation Bias

Blaming the yield curve for a market downturn is a narrative designed to fill the public need for an explanation on equity market losses. We talked to Peter Atwater, a behavioral specialist and guest on the Lance Roberts Show, to help us understand human behavior.

Per Peter: Confidence requires perceptions of certainty and control. Easily grasped narratives – even when they are woefully incorrect – fulfill both needs. Not sure that there is a formal name to the bias, but I would call it “Explanation Bias” – we need an easy story to fight against the anxiety that would arise from what would otherwise be randomness. And randomness is untenable.

We highly recommend following Peter on Twitter at @peter_atwater

In our need to explain and attempt to understand randomness, the public is now aware of a real and growing threat that was ignored just days prior. The sudden drop in the stock market and a potential catalyst for a much steeper decline is not necessarily about finance and economics; behavioral instincts are now in play.  

Over the past several months we have said the window for a potential recession is open. By this, we meant that economic stimulus was waning, global growth was slowing, and the potential for a recession has increased as a result. The hard part of our forecast was to name the catalyst that could tip the economy into recession.

We postulated that it might be the brewing trade war, Iran, slowing global growth, or any number of other topics in the media at the time. The problem, as we pointed out in naming a single catalyst or narrative, was that it really could be something inconsequential or something we have not pondered.

This concept is akin to avalanches. The structure of the hill, weather, and the way the snow is perched determine whether an avalanche will occur. The catalyst, however, is but one snowflake that causes a chain reaction.

It is possible the snowflake in our case is the media and the public’s awareness of the relationship between yield curve inversions and recessions.

If the headlines do spark new concern and even slightly modifies consumption patterns, a recession may come sooner than we think. If you harbor concerns that a recession is coming, aren’t you more likely to eat in or put off buying a new TV? These little and seemingly inconsequential decisions made by a minority of consumers can tip the scale and create negative economic growth.

Here is another way to think about it. Picture your favorite restaurant, one that is always packed and has a waiting list. One day you arrive on a Saturday night expecting to wait an hour for a table, but to your delight, the hostess says you can sit immediately. You look around and the restaurant is crowded, but uncharacteristically there are a few empty tables. Those empty tables, while seemingly insignificant, may mean the restaurant’s sales are down a few percent from the norm.

A few percent may not seem like a big deal, but consider that the average annual recessionary growth low point was only -1.88% for the last five recessions. If economic growth is weak, then small negative changes in output can take an economy from expansion to contraction quicker than if growth rates were stronger. This seems to exemplify the current situation as growth has been fairly tepid post-financial crisis.

Summary

We can follow all the economic data and trends diligently, but consumption accounts for over 70% of U.S. economic growth. Therefore, recessions ultimately tend to be the effect of changes in consumer behavior. If the narrative de jour is enough to trouble even a small percentage of consumers, the likelihood of a recession increases. The evidence of such a change will eventually turn up in sentiment surveys, and when it does, the problem has already taken root. This is not a dire warning of recession but rather offers consideration of a legitimate second-order effect that potentially threatens this record-long economic expansion. 

While the media focuses on the inversion narrative, alerting the public to recession warnings and driving consumers to re-think their planned purchases, we care more about when the yield curve will steepen. The steepening curve caused by aggressive Fed action after a curve inversion is the tried and true recession warning. For more, please read Yesterday’s Perfect Recession Warning May Be Failing You.

Special Report: S&P 500 Plunges On Yield Curve Inversion

Yesterday, the financial media burst into flames as the yield on the 10-year Treasury fell below that of the 2-Year Treasury. In other words, the yield curve became negative, or “inverted.”

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

According to CNBC’s logic, the economy was perfectly fine on Tuesday, notably as Trump delayed “tariffs” on China, since the yield curve was NOT inverted. However, in less than 24-hours, stocks are plunging because the yield curve inverted?

Let’s step back for a moment and think about this.

Historically speaking, the inversion of a yield curve has been a leading indicator of economic recessions as the demand for liquidity exceeds the demand for longer-term loans. The chart below shows the history of yield curves and recessions.

The yield curve has been heading towards an inversion for months, suggesting that something was “not healthy” about the state of the economy. In August 2018, I wrote, “Don’t Fear The Yield Curve?”

“The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Despite the flattening slope of the yield curve, the mainstream media was consistently dismissing the message it was sending.

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.” – James McCusker

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

While the nearly inverted yield curve didn’t matter on Tuesday, it suddenly mattered on Wednesday? From the WSJ:

“It was a very bad day in the stock market on Wednesday. That big rally on Tuesday after the U.S. delayed some China tariffs? Completely erased, and then quite a bit more. The Dow Jones Industrial Average fell 800 points, or 3%, and the S&P 500 dropped 2.9%.

A big factor in the selling appeared to be concern over a brief drop in the yield on the 10-year Treasury yield below the yield on the two-year. Since such yield curve inversions have tended to occur ahead of recessions, worries that the U.S. is at risk of downturn got set off.”

We have been warning for the last 18-months that despite a sharp rise in volatility, the bull market that began in 2009 had likely come to an end. To wit:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)”

The last highlighted phrase is THE most important. There is an old saying about “con men” which sums this idea up perfectly:

“Thieves run out of town. Con men walk.”

The goal of portfolio management is NOT to be forced into a liquidation event. Such doesn’t mean you must try and “time the market” to sell at the peak (which is impossible to do), but rather being aware of the risk you are carrying and exiting the market when you choose. Being put into a position, either “emotionally” or “operationally,” where you are forced to liquidate always occurs at the worst possible time and creates the greatest amount of capital destruction.

With this premise in place, let’s review the S&P 500 over several different time frames and metrics to determine what actions should be considered over the next few days and weeks.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we stretch the analysis out a bit, the “megaphone” pattern becomes much more apparent. The repeated failures at the upper trend line continues to complete a “broadening topping process,” which is more suggestive of a larger, more concerning market peak.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical green lines are buy periods, red lines are sell periods.)

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are close to confirming each other, and suggests a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the concerns rise even further. We have noted previously, the market had triggered a major “sell” signal in September of last year. These monthly signals are “rare,” and coincide with more important market events historically.

These signals should not be ignored.

Don’t Panic Sell

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the months ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 53.7% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

15-Portfolio Management Rules:

  • Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  • Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  • Emotionally driven decisions void the investment process.(Buy high/sell low)
  • Follow the trend.(80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  • Never let a “trading opportunity” turn into a long-term investment.(Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  • An investment discipline does not work if it is not followed.
  • “Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
  • The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  • Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  • Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short.(Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  • When markets are trading at, or near, extremes do the opposite of the “herd.”Do more of what works and less of what doesn’t.(Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  • “Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  • Strive to be a .700 “at bat” player.(No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  • Manage risk and volatility.(Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

UNLOCKED RIA PRO: S&P 500 Plunges On Yield Curve Inversion

We have unlocked yesterday’s report that went out to our RIA PRO subscribers following the crash. You can subscribe at RIAPRO.NET and get 30-DAYS FREE to gain access to our portfolio models, analysis, and research.

Yesterday, the financial media burst into flames as the yield on the 10-year Treasury fell below that of the 2-Year Treasury. In other words, the yield curve became negative, or “inverted.”

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

According to CNBC’s logic, the economy was perfectly fine on Tuesday, notably as Trump delayed “tariffs” on China, since the yield curve was NOT inverted. However, in less than 24-hours, stocks are plunging because the yield curve inverted?

Let’s step back for a moment and think about this.

Historically speaking, the inversion of a yield curve has been a leading indicator of economic recessions as the demand for liquidity exceeds the demand for longer-term loans. The chart below shows the history of yield curves and recessions.

The yield curve has been heading towards an inversion for months, suggesting that something was “not healthy” about the state of the economy. In August 2018, I wrote, “Don’t Fear The Yield Curve?”

“The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Despite the flattening slope of the yield curve, the mainstream media was consistently dismissing the message it was sending.

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.” – James McCusker

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

While the nearly inverted yield curve didn’t matter on Tuesday, it suddenly mattered on Wednesday? From the WSJ:

“It was a very bad day in the stock market on Wednesday. That big rally on Tuesday after the U.S. delayed some China tariffs? Completely erased, and then quite a bit more. The Dow Jones Industrial Average fell 800 points, or 3%, and the S&P 500 dropped 2.9%.

A big factor in the selling appeared to be concern over a brief drop in the yield on the 10-year Treasury yield below the yield on the two-year. Since such yield curve inversions have tended to occur ahead of recessions, worries that the U.S. is at risk of downturn got set off.”

We have been warning for the last 18-months that despite a sharp rise in volatility, the bull market that began in 2009 had likely come to an end. To wit:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)”

The last highlighted phrase is THE most important. There is an old saying about “con men” which sums this idea up perfectly:

“Thieves run out of town. Con men walk.”

The goal of portfolio management is NOT to be forced into a liquidation event. Such doesn’t mean you must try and “time the market” to sell at the peak (which is impossible to do), but rather being aware of the risk you are carrying and exiting the market when you choose. Being put into a position, either “emotionally” or “operationally,” where you are forced to liquidate always occurs at the worst possible time and creates the greatest amount of capital destruction.

With this premise in place, let’s review the S&P 500 over several different time frames and metrics to determine what actions should be considered over the next few days and weeks.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we stretch the analysis out a bit, the “megaphone” pattern becomes much more apparent. The repeated failures at the upper trend line continues to complete a “broadening topping process,” which is more suggestive of a larger, more concerning market peak.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical green lines are buy periods, red lines are sell periods.)

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are close to confirming each other, and suggests a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the concerns rise even further. We have noted previously, the market had triggered a major “sell” signal in September of last year. These monthly signals are “rare,” and coincide with more important market events historically.

These signals should not be ignored.

Don’t Panic Sell

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the months ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 53.7% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

15-Portfolio Management Rules:

  • Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  • Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  • Emotionally driven decisions void the investment process.(Buy high/sell low)
  • Follow the trend.(80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  • Never let a “trading opportunity” turn into a long-term investment.(Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  • An investment discipline does not work if it is not followed.
  • “Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
  • The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  • Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  • Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short.(Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  • When markets are trading at, or near, extremes do the opposite of the “herd.”Do more of what works and less of what doesn’t.(Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  • “Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  • Strive to be a .700 “at bat” player.(No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  • Manage risk and volatility.(Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

Fixed Income Review – July 2019

We delayed publishing the July Fixed Income Review so we can present fresh data and comment on the surge in volatility following the Fed meeting (7/31) and new tariffs on China (8/1). 

In general, the fixed income markets were mostly sleep-walking through July in anticipation of a July 31st Federal Reserve rate cut and a much-anticipated dovish statement from the Fed.  As if on autopilot, stock markets slogged higher and credit spreads moved tighter throughout the month. Meanwhile, Treasury yields rose modestly after their dramatic declines in May and June. Indeed, as the table below reflects, Treasuries were the only major fixed-income class to lose ground on a total return basis in July. All other categories posted positive returns for the month.

In stark contrast, the ETF table below highlights some of the significant changes we have seen since the beginning of August.

Following the Federal Open Market Committee (FOMC) meeting on July 31 and the subsequent press conference delivered by Chairman Jerome Powell, the future of monetary policy was suddenly in question. For the first time in several months, the Fed failed to deliver a dovish surprise.

Part of Powell’s response to the first question in the press conference regarding the “hurdle” for further rate cuts was as follows:

“…the committee is really thinking of this as a way of adjusting policy to a somewhat more accommodative stance to further the three objectives that I mentioned. To ensure against downside risks, to provide support to the economy that those factors are pushing down on economic growth and then to support inflation. So, we do think it’ll serve all of those goals. But again, we’re thinking of it as essentially in the nature of a midcycle adjustment to policy.”

Despite the evidence and assurances of rate cuts to provide a firebreak against any potential weakening of the economy, Powell’s reference to “a midcycle adjustment” suddenly raised doubts about their conviction for further easing.  

Given the strength of the U.S. economy, the “downside risks” he refers to are clearly emanating from foreign sources. Now add a Fed that may not be ready to cut rates further and the renewed escalation of the trade war between the U.S. and China and one has a potent cocktail for the volatility seen since the end of July.

As can be seen in the tables above, fixed-income markets in July were mostly a non-event but the first several days of August have been full of fireworks. The table below illustrates the move in U.S. Treasury yields since July 31.

Investment grade and high yield markets reacted with some displeasure to Jerome Powell’s comments and new rhetoric from the administration on trade and tariff challenges associated with China. Although the magnitude of the spread changes did not breach any meaningful technical levels, the speed of the change was rather head-snapping.

We end up in a familiar place. If we are to take the Chairman at his word and potential downside risks warrant a rate cut, it becomes even more challenging to justify the valuations investors are being asked to pay to own risky assets. Despite having posted new highs in recent weeks, the S&P 500 has produced a 3.48% annualized total return over the past 18 months along with volatility of 15.5%. High yield bonds have delivered annualized total returns of 4.80% with 12.9% volatility. Net out the most recent inflation data of 1.6% from those numbers and we struggle to understand why investors have been so enthusiastic.

Eighteen months ago, one could buy 10-year Treasuries at a 2.85% yield. The 7-10 year ETF (Ticker: IEF) has delivered 3.55% total return and with only 4.4% volatility. Needless to say, while not glamorous, the risk-free route provided returns on par with stocks and high-yield but with significantly less volatility. Given the risks Chairman Powell has outlined, might Treasuries, despite near-record low yields, be the safe place to hide in fixed income for the time being? Astute, rational investors will either figure that out on their own or the market will impose its will.

All Data Courtesy Barclays

Strongest Economy Ever? I Warned You About Negative Revisions

Over the last 18-months, there has been a continual drone of political punditry touting the success of “Trumponomics” as measured by various economic data points. Even the President himself has several times taken the opportunity to tweet about the “strongest economy ever.”

But if it is the “strongest economy ever,” then why the need for aggressive rate cuts which are “emergency measures” to be utilized to offset recessionary conditions?

First, it is hard to have an “aggressive rate-cutting cycle” when you only have 2.4% to work with.

Secondly, I am not sure we want to be like China or Europe economically speaking, and running a $1.5 Trillion deficit during an expansion, suspending the debt ceiling, and expanding spending isn’t that much different.

Nonetheless, I have repeatedly cautioned about the risk of taking credit for the economic bump, or the stock market, as a measure of fiscal policy success. Such is particularly the case when you are a decade into the current economic cycle.

Economic growth is more than just a reported number. The economy has been “in motion” following the last recession due to massive liquidity injections, zero interest rates, and a contraction in the labor force. Much like a “snowball rolling downhill,” the continuation of economic momentum should have been of little surprise.

As an example, we can look at full-time employment (as a percentage of 16-54  which removes the “retiring baby boomer” argument) by President. The rise in full-time employment has been on a steady trend higher following the financial crisis as the economic and financial systems repaired themselves.

As discussed previously, economic data is little more than a “wild @$$ guess” when it is initially reported. However, one-year and three-years later, the data is revised to reveal a more accurate measure of the “real” economy.

Unfortunately, we pay little attention to the revisions.

While there are many in the media touting “the strongest economy ever” since Trump took office, a quick look at a chart should quickly put that claim to rest.

Yes, there was a spurt in economic growth during 2018, which did seem to support the claims that Trump’s policies were working. As I warned then, there were factors at play which were obfuscating the data.

“Lastly, government spending has been very supportive to the markets in particular over the last few quarters as economic growth has picked up. However, that “sugar-high” was created by 3-massive Hurricanes in 2017 which has required billions in monetary stimulus which created jobs in manufacturing and construction and led to a temporary economic lift. We saw the same following the Hurricanes in 2012 as well.”

“These “sugar highs” are temporary in nature. The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth.”

The importance is that economic “estimates” become skewed by these exogenous factors, and I have warned these over-estimations would be reversed when annual revisions are made.

Last week, the annual revisions to the economic data were indeed negative. The chart below shows “real GDP” pre- and post-revisions.

This outcome was something I discussed previously:

With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a ‘neutral rate,’ it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.”

However, there is further evidence that actual, organic, economic growth is weaker than the current negative revisions suggest. More importantly, the revisions to the 2019 data, in 2020, will very likely be as negative as well.

This is also the case with the employment data which I discussed previously:

“Months from now, the Establishment Survey will undergo its annual retrospective benchmark revision, based almost entirely on the Quarterly Census of Employment and Wages conducted by the Labor Department. That’s because the QCEW is not just a sample-based survey, but a census that counts jobs at every establishment, meaning that the data are definitive but take time to collect.”

“The Establishment Survey’s nonfarm jobs figures will clearly be revised down as the QCEW data show job growth averaging only 177,000 a month in 2018. That means the Establishment Survey may be overstating the real numbers by more than 25%.”

There is nothing nefarious going on here.

It is the problem with collecting data from limited samples, applying various seasonal adjustment factors to it, and “guesstimating” what isn’t known. During expansions, the data is always overstated and during recessions it is understated. This is why using lagging economic data as a measure of certainty is always erroneous.

Debt-Driven Growth

I recently discussed the “death of fiscal conservatism” as Washington passed another spending bill.

“In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in.”

The “good news” is, if you want to call it that, is that Government spending does show up in economic growth. The “bad news” is that government spending has a negative “multiplier” effect since the bulk of all spending goes to non-productive investments. (Read this)

Nonetheless, the President suggests we are “winning.”

The problem is that economic growth less government spending is actually “recessionary.” 

As shown in the chart below, since 2010 it has taken continually increases in Federal expenditures just to maintain economic growth at the same level it was nearly a decade ago. Such a “fiscal feat” is hardly indicative of “winning.”

As Mike Shedlock noted, part of the issue with current economic estimates is simply in how it is calculated.

In GDP accounting, consumption is the largest component. Naturally, it is not possible to consume oneself to prosperity. The ability to consume more is the result of growing prosperity, not its cause. But this is the kind of deranged economic reasoning that is par for the course for today.

In addition to what Tenebrarum states, please note that government transfer payments including Medicaid, Medicare, disability payments, and SNAP (previously called food stamps), all contribute to GDP.

Nothing is “produced” by those transfer payments. They are not even funded. As a result, national debt rises every year. And that debt adds to GDP.”

This is critically important to understand.

While government spending, a function of continually increasing debt, does appear to have an economic benefit, corporate profits tell a very different story.

The Real Economy

I have been noting for a while the divergence between “operating earnings” (or rather “earnings fantasy”) versus corporate profits which are what companies actually report for tax purposes. From “Earnings Growth Much Weaker Than Advertised:”

“The benefit of a reduction in tax rates is extremely short-lived since we compare earnings and profit growth on a year-over-year basis.

In the U.S., the story remains much the same as near-term economic growth has been driven by artificial stimulus, government spending, and fiscal policy which provides an illusion of prosperity.”

Since consumption makes up roughly 70% of the economy, then corporate profits pre-tax profits should be growing if the economy was indeed growing substantially above 2%.”

We now know the economy wasn’t growing well above 2% and, as a consequence, corporate profits have been revised sharply lower on a pre-tax basis.

The reason we are looking at PRE-tax, rather than post-tax, profits is because we can see more clearly what is actually happening at the corporate level.

Since corporate revenues come for the sale of goods and services, if the economy was growing strongly then corporate profits should be reflective of that. However, since 2014, profits have actually been declining. If we take the first chart above and adjust it for the 2019-revisions we find that corporate profits (both pre- and post-tax) are the same level as in 2012 and have been declining for the last three-years in particular.

Again, this hardly indicates the “strongest economy in history.”

These negative revisions to corporate profits also highlight the over-valuation investors are currently paying for asset prices.  Historically, such premiums have had rather horrific “paybacks” as markets eventually “reprice” for reality.

Trump’s Political Risk

While the media is quick to attribute the current economic strength, or weakness, to the person who occupies the White House, the reality is quite different.

Most fiscal, and monetary, policy changes can take up to a year before the impact shows in the economic data. While changes to “tax rates” can have a more immediate impact, “interest rate” changes take longer to filter through.

The political risk for President Trump is taking too much credit for an economic cycle which was already well into recovery before he took office. Rather than touting the economic numbers and taking credit for liquidity-driven financial markets, he should be using that strength to begin the process of returning the country to a path of fiscal discipline rather than a “drunken binge” of spending.

With the economy, and the financial markets, sporting the longest-duration in history, simple logic should suggest time is running out.

This isn’t doom and gloom, it is just a fact.

Politicians, over the last decade, failed to use $33 trillion in liquidity injections, near zero interest rates, and surging asset prices to refinance the welfare system, balance the budget, and build surpluses for the next downturn.

Instead, they only made the deficits worse and the U.S. economy will enter the next recession pushing a $2 Trillion deficit, $24 Trillion in debt, and a $6 Trillion pension gap which will devastate many in their retirement years.

While Donald Trump talked about “Yellen’s big fat ugly bubble” before he took office, he has now pegged the success of his entire Presidency on the stock market.

It will likely be something he eventually regrets.

“Then said Jesus unto him, Put up again thy sword into his place: for all they that take the sword shall perish with the sword.” – Matthew 26, 26:52

Steepening Yield Curve Could Yield Generational Opportunities : Michael Lebowitz on Real Vision

On July 1st, Michael Lebowitz was interviewed by Real Vision TV. In the interview he discussed our thoughts on the yield curve, corporate bonds, recession odds, the Federal Reserve, and much more. In particular, Michael pitched our recent portfolio transactions NLY and AGNC, which were both discussed in the following RIA PRO article: Profiting From a Steepening Yield Curve.

Real Vision was kind enough to allow us to share their exclusive video with RIA Pro clients. We hope you enjoy it.

To watch the Video please click HERE

Fixed Income Review – June 2019

As central banks have become collectively more dovish throughout 2019, monetary stimulus appears to be back in control of the economic cycle. The Federal Reserve ratcheted up their easing posture at the June Federal Open Market Committee (FOMC) meeting as one voting member dissented from the group in favor of a rate cut. There were other non-voting members even arguing for a 50 basis point rate cut on concerns about the economic outlook and still muted inflation pressures. Keep in mind this abrupt flip in policy is coming despite unemployment at near half-century lows and inflation hovering around 2.0%, the supposed Fed target.

With that backdrop in play, it is no surprise that June was a good month for all risk assets. Within the Fixed income arena, the riskiest of bonds outperformed against the spectrum of safer fixed-income products. As the table below highlights, every major category performed well with emerging markets (EM) leading the way and investment grade (IG) and high yield (HY) corporate returns close behind.

Fixed income has now completed a “round trip” from June 2018 as yields and spreads in almost every category are back below the levels observed at the same time last year. The tables below illustrate those moves in both yields and spreads.

The anticipation of what is being called “insurance rate cuts” from the Fed as well as easing measures expected from the European Central Bank (ECB), offered investors comfort that these potential actions will keep downside risk and volatility at bay. The hope is that the central bankers are sufficiently ahead of the curve in combating weaker global growth.

Despite investor optimism about the outlook as evidenced in the first half performance, risks remain. Most notably, ongoing deceleration in trade and industrial activity could worsen and bring an end to the current record-long economic U.S. expansion. The United States is surrounded by economies that are faltering, including Canada, Australia, Europe, Japan, much of southeast Asia and, most importantly, China. The Trump trade policy agenda only adds to these risks, especially for those countries dependent on exports for economic growth.

If risks do not abate, then we should expect forceful actions from central bankers. The common response of Treasury yields and the yield curve is for the short end (out to two- or three-year maturities) to drop significantly and the long end to either hold steady or fall but much less so than short rates resulting in what is called a bullish curve steepener. As we discussed in Yesterday’s Perfect Recession Warning May Be Failing You, past episodes of rate cuts illustrate this effect.

With investors complacent, yields and spreads on risky assets back to extremely rich levels, and global trouble brewing, the pleasant by-product of recent Fed rhetoric might quickly be disrupted. If so, the gains of the first half of 2019 would become a vague memory.

Apart from slowing global trade and industrial activity, keep in mind there are plenty of other potentially disruptive issues at hand including China leverage, Brexit, the contentious circumstances between the U.S. and Iran, the Italian government fighting with the European Commission on fiscal issues, Turkish currency depreciation, on-going problems in Argentina and more.

At the moment, the Fed and the ECB appear to have the upper hand on the markets, and higher yielding asset alternatives that reward an investor for taking risk are benefiting. Still, a critical assessment of the current landscape demands that investors engage and think critically about the risk-reward trade-off under current circumstances. The Fed and the ECB are not hyper-cautious and dovish for no reason at all. There is more to the current economic dynamic than meets the passive observer’s eye.

All Data Courtesy Barclays

Profiting From A Steepening Yield Curve

What is the yield curve and what does it mean for the economy and the markets?

Over the last few months, the financial media has obsessed on those questions. Given the yield curve’s importance, especially considering the large amount of debt being carried by individuals, corporations, and the government, we do not blame them. In fact, we have given our two cents quite a few times on what a flattening and inversion of various yield curves may be signaling. Taking our analysis a step further, we now look at investment ideas designed to take advantage of expected changes in the yield curve.

An inversion of the 2yr/10yr Treasury yield curve, where yields on 10-year Treasury notes are lower than those of 2-year Notes, has accurately predicted the last five recessions. This makes yield curve signaling significant, especially now. It is important to note that in the five prior instances of yield curve inversions, the recession actually started when, or shortly after, the yield curve started to steepen to a more normal positive slope following the inversion. In our opinion, the steepening, and not the flattening or inversion of the curve, is the recession indicator.  

As discussed in Yesterday’s Perfect Recession Warning May Be Failing You, we believe the 2yr/10yr curve may not invert before the next recession. It may have already troughed at a mere 0.11 basis points on December 19, 2018. If we are correct, the only recession warning investors will get could be the aforementioned curve steepening. Another widely followed curve spread, the yield difference between 3-month Treasury bills and 10-year Treasury notes, recently inverted and troughed at -25 basis points, which makes the likelihood of a near-term recession significant.

The remainder of this article focuses on REITs (real-estate investment trusts). Within this sector lies an opportunity that should benefit if the yield curve steepens, which we noted has occurred after an initial curve inversion and just before the onset of the last five recessions.  

What is an Agency Mortgage REIT?

REITs are companies that own income-producing real estate and/or the debt backing real estate. REITs tend to pay higher than normal dividends as they are legally required to pay out at least 90% of their taxable profits to shareholders annually. Therefore, ownership of REIT common equity requires that investors analyze the underlying assets and liabilities of the REIT to assess the potential flow of income, and thus dividends, in the future.  

The most popular types of REITs are called equity REITs. These REITs own equity in apartments and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREITs), which own the debt (mortgages) on real-estate properties. Within this sector is a subset known as Agency mREITs (AmREITs) that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

From an investor’s point of view, a key distinguishing characteristic between equity REITs and mREITs is their risk profiles.  The shareholders of equity REITs are chiefly concerned with vacancy rates, rental rates, and property values.  Most mREIT shareholders, on the other hand, worry about credit risk and interest rate risk. Interest risk is the yield spread between borrowing rates and the return on assets. AmREITS that solely own agency guaranteed mortgages assume no credit risk as timely payment of principal and interest is advanced by the security issuer (again either Fannie Mae, Freddie Mac, or Ginnie Mae, all of whom are essentially government guaranteed). Therefore, returns on AmREITs are heavily influenced by interest rate risk. Almost all REITs employ leverage, which enhances returns but adds another layer of risk.

Agency mREITs

Earnings for AmREITs are primarily the product of two sources; the amount of net income (yield on mortgages they hold less the cost of debt and hedging) and the amount of leverage.

A typical AmREIT is funded with equity financing and debt. The capital is used to purchase government-guaranteed mortgages. Debt funding allows them to leverage equity. For example, if a REIT bought $5 of assets with $1 of equity capital and $4 of debt, they would be considered 5x leveraged (5/1). Leverage is one way REITs enhance returns.

The second common way they enhance returns is to run a duration gap. A duration gap means the REIT is borrowing in shorter maturities and investing in long maturities. A 2-year duration gap implies the REIT has an average duration of their liabilities that is two years less than the duration of their assets. To better manage the duration gap and the associated risks, REIT portfolio managers hedge their portfolios. 

The Fed’s Next Move and AmREITs

With that bit of knowledge, now consider the Fed’s quickly changing policy stance, how the yield curve might perform going forward, and the potential impact on REITs.

Recent speeches from various Fed members including Chairman Powell and Vice Chairman Clarida are leading us and most market participants to believe the Fed could lower rates as early as the July 31st FOMC meeting. Most often, yield curves steepen when, or shortly before, the Fed starts lowering rates. While still too early to declare that the yield curve has troughed, it has risen meaningfully from recent lows and is now the steepest it has been since November of 2018.  

If we are correct that the Fed reduces the Fed Funds rate and the yield curve steepens, then AmREITs should benefit as their borrowing costs fall more than the yields of their assets. Further, if convinced of a steepening event, portfolio managers might reduce their hedging activity to further boost income. The book value of AmREITs have a strong positive correlation with the yield curve, and as a result, the book value per share of AmREITs should increase as the curve steepens.

The following two graphs compare the shape of the 2yr/10yr yield curve versus the book value per share for the two largest AmREITs, Annaly Capital Management (NLY) and AGNC Investment Corporation (AGNC). The third and fourth graphs below show the same data in scatter plots to appreciate the correlation better. The current level of book value per share and yield curve is represented by the orange blocks in each scatter plot. Statistically speaking, a one percent steepening of the yield curve should increase the book value per share by approximately $2 for both stocks. Given both stocks have dividend yields in the low double-digits, any book value appreciation that results in price appreciation would make a good return, great.

Data Courtesy Bloomberg

While a steepening yield curve will likely create more spread income and thus a higher book value for these REITs, we must also consider the role of leverage and the premium or discount to book value that investors are currently paying.  

  • NLY is employing 8.2x leverage, which is slightly higher than their average of 7.6x since 2010, but less than their 20+ year average of 9.94.
  • AGNC uses more leverage at 10.2x, which is higher than their average of 8.8x since 2010. The REIT was formed in late 2008, therefore we do not have as much data as NLY. 
  • NLY trades at a discounted price to book value of .94, slightly below their historical average
  • AGNC also trades at a discounted level of .92 and below their historical average.

The risks of buying AGNC or NLY are numerous.

  • We may be wrong about the timing of rate cuts and the curve may continue to invert, which would decrease book value. In such a case, we may see the book value decline, and potentially even more damaging, the discount to book value decreases further, harming shareholders.
  • Even if we are right and the yield curve steepens and the REITs asset/liability spreads widen, we run the risk that investors are nervous about real-estate going into recession and REITs trade to deeper discounts to book value and effectively offset any price appreciation due to the increase in book value.
  • Leverage is easy to maintain when markets are liquid; however, as we saw a decade ago, REITs were forced to sell assets and reduce leverage which can also negatively affect earnings and dividends. It is worth noting that NLY had an average of 12.90x leverage in 2007, which is significantly larger than their current 8.20x.

Summary

Despite double-digit dividend yields and the cushion such high dividends provide, buying NLY or AGNC is not a guaranteed home run. The two REITs introduce numerous risks as mentioned.  That said, these firms and other smaller AmREITs, offer investors a way to take advantage of a steepening yield curve while avoiding an earnings slowdown that may hamper many stocks in an economic downturn.

While NLY and AGNC are in the same industry, they use different portfolio tactics to express their views. As such, if you are interested in the sector, we recommend diversifying among these two companies and others to help reduce idiosyncratic portfolio risks. We also recommend investors assess the IShares Mortgage Real ETF (REM). Its two largest holdings, accounting for over 25% of the ETF, are NLY and AGNC.  It is worth noting however, this ETF introduces risks not found in the AmREITs. The ETF holds the shares of mortgage REITs that contain non-guaranteed mortgages as well as mortgages on commercial properties.

Fixed Income Review – May 2019

To quote from last month’s FI Review, “The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds are becoming more obvious…

On the surface, it looks as though fixed income had another excellent month with the exception of the high yield (junk) sector. Year-to-date, total return gains range from between 3.5% (MBS, ABS, CMBS) to 7.3% (junk). With equity markets up 9-10% through May, bonds are, to use horse racing vernacular, holding pace and stalking. But the monthly total return data does not tell the whole story as we shall see.

To start with an important backdrop for all asset classes, the decline in yields during May was eye-catching and most notable was the sharp inversion of the 3-month to 10-year curve spread. The table below highlights yield changes for May and the curve inversion.

The graph below shows the yields on the 3-month T-bill and the 10-year Treasury note as well as the yield spread between the two. Past inversions of this curve have tended to signal the eventuality of a recession, so this is a meaningful gauge to watch.

To reference the lead quote above, we maintain that spread tightening has most likely run its full course for this cycle and performance will largely be driven by carry. That said, we offer caution as the risk of spread widening across all credit sectors is high, and May might be offering clues about what may yet come.

The first four months of the year highlighted excellent risk-on opportunities. However, with Treasury yields now falling dramatically, they seem to signal bigger problems for the global and domestic economy than had previously been considered. The Treasury sector handily outperformed all others in May and higher risk categories (Junk and EM) were the worst performers. This is a reversal from what we have seen thus far in 2019.

Summer winds are blowing in trouble from the obvious U.S.-China trade dispute but also from Italy, Brexit, Iran, and Deutsche Bank woes.

To highlight the relationship between the historical and recent month-over-month moves in the S&P 500 returns and those of investment grade and high yield bonds, the scatter chart below offers some compelling insight. The green marker on each graph is the month of April, and the red marker is May.

Investment grade bonds have less sensitivity to equity market moves (trendline slope 0.124) and, as we should expect, high yield bonds have return characteristics that closer mimics that of the stock market (trendline slope 0.474). The scales on the two graphs are identical to further stress the differences in return sensitivity.

Finally, when looking at the spread between 5-year Treasuries and investment-grade bonds (similar duration securities) versus the spread between 5-year Treasuries and high-yield bonds, the spread widening since the end of April has been telling.

The investment grade spread to Treasuries widened by .019% (19 bps) and .82% (82 bps) against junk. Netting the risk-free interest rate move in Treasuries for May reveals that the pure excess return for the investment grade sector was -1.39% and for high yield it was -2.49%.

The month of May offered a lot of new information for investors. Most of it is highly cautionary.

All Data Courtesy Bloomberg and Barclays

Yes, The Yield Curve Matters

Recently several subscribers asked us why an inverted yield curve is a strong predictor of a coming recession. We will address the question in this article but first, we provide current context with two graphs that update you on the status of yield curves, and in the process help explain why this question is being asked with increasing frequency.

The first graph below, courtesy of the St. Louis Federal Reserve, clearly shows why the yield curve is becoming more and more of a concern for the Federal Reserve, along with many economists and the media. Since 1976, the last five recessions, denoted by gray bars, were preceded by a flattening and inversion of the 2yr/10yr Treasury yield curve. Currently, the curve is sitting at a mere 17 basis points (0.17%) and threatening inversion.

While the 2yr/10yr curve is the most popular yield curve to follow, it can be somewhat limiting as it only applies to those that borrow and lend in the two and ten-year maturity sectors. For example, the 2yr/10yr curve is not as important for a bank considering using customer deposits to make five-year auto loans. In this case, the bank’s chief concern is likely the 3-month/5yr curve.

The next graph steps beyond the 2yr/10yr curve to examine many variations of Treasury curves and provide a broader perspective of the entire Treasury yield curve.

As shown, 70% of 10 important yield curves are inverted, up from 40% in early April.

With an understanding of the current state of the yield curves, we examine the profitability of lending to explain better why the yield curve has such a big effect on the economy.

The Profitability of Lending

There are essentially two ways that a bank or lender makes money lending. They can arbitrage time or credit, and most frequently they do both at the same time. Lenders employ time arbitrage when they borrow for short periods and lend that same money out for longer periods. Credit arbitrage occurs when a higher rated entity with a lower cost of capital borrows and then lends to a borrower with a lower credit standing and higher cost of capital.

Time Arbitrage: This is the oldest money-making trick in the book. It is frequently referred to as borrowing short and lending long. The risk to the lender of using time arbitrage is that short term borrowing rates rise in the future and effectively reduce or eliminate profits. An inverted yield curve, coupled with poor lending practices was the cause of the Savings and Loan crisis of 1987-1989.

The steeper the yield curve, the more potential profit, and the more incentive for a bank to borrow short and lend long. Conversely, the flatter the curve the less incentive. An inverted curve can lead to losses for lenders employing this strategy.

The key takeaway is that in an economy heavily dependent on the creation and refunding of debt, anything that detracts from a willingness to lend money causes economic weakness.

Credit Arbitrage: The riskier a borrower, the higher the interest rate to borrow money. Banks tend to be highly rated, thus allowing them to borrow at lower rates and then turn around and lend the money to lesser rated borrowers at higher rates. As the shape of the yield curve greatly affects time arbitrage, credit spreads play a big role in credit arbitrage. When spreads are tight, as they are now, the potential profit of lending is reduced, and therefore lenders are less incentivized to lend. Currently, credit spreads, as quantified by BBB-rated corporate bonds, are historically tight. Once default expectations are factored in the incentive to lend is minimal. 

Quantifying Profitability

With an understanding of the two predominant types of lender arbitrages, we now provide a rough estimate of banking profitability based on the 2yr/10yr yield curve as a proxy for time arbitrage and BBB-rated corporate OAS spreads as a proxy for credit arbitrage. The following graph combines the two measures of probability to quantify the incentive for banks to lend.

Not surprisingly, the most recent recessions occurred when profitability, using these measures collapsed. The current reading is at levels seen before the 2001 recession and slightly above those preceding the financial crisis of 2008.

Data Courtesy St. Louis Federal Reserve

Summary

Tax reform, hurricane/fire disaster relief and a surge in the government’s deficit all provided an economic boost over the last few years. As we have written in the past, these economic tailwinds will no longer meaningfully contribute to economic growth. Real gross domestic production (GDP) will likely shrink to its natural growth rate of 1.5-2.0%. However, flat to inverted yields curves and tight credit spreads are becoming a headwind to growth.

If the yield curves stay flat and/or flattens or inverts further and credit spreads remain tight, it is highly likely lending will be curtailed. Assuming this were to happen, we could be staring down the barrel of another recession, which is what the bond markets appear to be telegraphing. That is why the yield curve matters!

Fixed Income Review – April 2019

The positive trends of the first quarter extended into April with broad-based total return gains across nearly every major fixed-income category. Only the safest corners of the bond markets posted negative returns last month, albeit those losses were quite minor in contrast with the positive returns since the end of 2018.

Returns in April, across the spectrum of indices, were not as impressive as those seen in the first three months of the year. No one expected those types of moves nor would anyone, having enjoyed them, expect them indefinitely. The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds, especially in credit-sensitive sectors, are becoming more obvious as we will discuss below.

As mentioned, the only two modest losers in April were Treasuries and securitized products (mortgages, asset-backeds, and commercial mortgages). Otherwise, the high yield sector again won the day head and shoulders above investment grade corporates, the next closest performer. According to the heat map below, like last month, all sectors are green across all longer time frames adding emphasis to the impressive rally seen since Christmas.

We would not speculate on the likelihood of this trend continuing, as odds favor a weaker performance trajectory. That does not mean poor performance, but risks rise with prices and spreads perched at historically tight levels.

The charts below illustrate the option-adjusted spreads (OAS) for the major categories in the corporate universe. They have all tightened dramatically since the end of the year. If we are correct that the spread tightening is largely done, then the preference would be to play for safety, and some interest carry for the next few months. In doing so, one may miss another unexpected move tighter in very risky high yield bond spreads; however, given current spread levels, one may also avoid increased odds of poor performance and possible losses.

Understanding that compounding wealth depends on avoiding large, damaging, emotional losses we would prefer to accept the risk of lower returns with high-grade securities while reducing our exposure to the riskier, more volatile sectors.

Although cheapening more dramatically than the Investment Grade (IG) sector in the fourth quarter, High Yield (junk) bonds recaptured much of that in the first four months of this year and in doing so returns junk bonds to (more than) full-value status.

The same can also be said for the lower credit sectors within the IG population. A long-term perspective offers proper context for where valuations are today relative to the past 25 years. The risk is clearly skewed to wider credit spreads and cheaper valuations (losses).

The Trend Continues

The recent tightening of spreads offers little new to discuss other than some deceleration of price and spread action. Importantly, and as recent articles have emphasized, this is a very late stage cycle rally. Risks are rising that corporate margin headwinds, slowing global economic activity, and a high bar for rate cuts given the optical strength of the economy limit the scope for price and spread gains in credit.

Overweighting lower rated credit sectors of the fixed income market is currently akin to the well-known phrase “picking nickels up in front of a steam roller.”

All Data Courtesy Barclays

Fixed Income Review – March 2019

The first quarter of 2019 offered one of the most powerful surges in risky asset valuations seen in history. Closing at 2506 on December 31, 2018, the S&P 500 proceeded to rise 328 points (14.37%) to 2834 in the first quarter. The near vertical leap skyward corresponds directly to the abrupt change in posture from the Federal Reserve (Fed) as they eliminated all threats of rate hikes in 2019. They took the further step of announcing a schedule to halt quantitative tightening (QT).

As might be expected, high yield credit was the best performing sector for the quarter with a total return of 7.26%. Somewhat counter-intuitively, U.S. Treasuries (+2.11%) also rallied for the quarter although they lagged all other major fixed-income sectors as shown in the table below.

For March, risk markets stalled slightly after the big run in the prior two months. Although posting returns of nearly 1%, high yield was the worst performer while investment grade was the best.

The contrast in performance between high-quality and low-quality bonds may be telling. In what could be a related issue, interest rate volatility in the U.S. Treasury market as measured by the MOVE Index spiked higher mid-month and had implications for the credit markets.

As shown in the tables below, only the BBB spread tightened slightly with all others widening by 1-3 basis points. Putting it together, despite solid total returns for the month, the spread widening tells us that corporate credit did not keep pace with falling Treasury yields in March, particularly at the end of the month.

From a macro perspective, the changes in Treasury yields and the yield curve raise broad concerns. Namely, are we nearing the end of the current expansion? As discussed in far more detail in our prior article, Yesterday’s Perfect Recession Warning May Be Failing You, the yield curve has a durable track record of signaling major changes in the economic cycle especially when it inverts (longer-term interest rates drop below short-term rates). When an inverted curve is considered with the end of a Fed rate hike cycle, the evidence becomes even more compelling. The Fed abruptly altered their outlook for monetary policy in March putting to rest any concern for further hikes. The market is now pricing for 1 or 2 rate cuts in 2019.

The last time we observed this combination of circumstances, an inverted curve and a market implying fed funds rate cuts, was ominously in late 2006. In October of last year, when the yield curve spread was decidedly positive, most economists including National Economic Council director Larry Kudlow pointed to this barometer and said we were nowhere near recession. The current market narrative now claims we should not pay too much attention to this important historical precedent. As opposed to trying to shape the narrative to suit our interests, we prefer instead to heed history. The odds are that this time is not different.

Time will tell.

All data sourced from Bloomberg and Barclays

Trying To Be Consistently “Not Stupid”

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger

As described in a recent article, Has This Cycle Reached Its Tail, an appreciation for where the economy is within the cycle of economic expansion and contraction is quite important for investors. It offers a gauge, a guidepost of sorts, to know when to take a lot of risk and when to take a conservative approach.

This task is most difficult when a cycle changes. As we are in the late innings of the current cycle, euphoria is rampant, and everyone is bullish. During these periods, as risks are peaking, it is very challenging to be conservative and make less than your neighbors. It is equally difficult taking an aggressive stance at the depths of a recession, when risk is low, despair is acute, and everyone is selling.

What we know is that a downturn in the economy, a recession, is out there. It is coming, and as Warren Buffett’s top lieutenant Charlie Munger points out in the quote above, successful navigation comes down to trying to make as few mistakes as possible.

The Aging Expansion

In May 2019, the current economic expansion will tie the expansion of 1991-2001 as the longest since at least 1857 as shown below. 

Since gingerly exiting the financial crisis in June 2009, the economy has managed to maintain a growth trajectory for ten years. At the same time, it has been the weakest period of economic growth in the modern era but has delivered near-record gains in the stock market and significant appreciation in other risk assets. The contrast between those two issues – weak growth and record risky financial asset appreciation make the argument for caution even more persuasive at this juncture.

Although verbally reinforcing his optimistic outlook for continued economic growth, Federal Reserve (Fed) Chairman Jerome Powell and the Federal Open Market Committee (FOMC) did not inspire confidence with their abrupt shift in monetary policy and economic outlook over the past three months.

The following is a list of considerations regarding current economic circumstances. It is a fact that the expansion is “seasoned” and quite long in the tooth, but is that a reason to become cautious and defensive and potentially miss out on future gains? Revisiting the data may help us avoid making a mistake or, in the words of Munger, be “not stupid.”

1. Despite the turmoil of the fourth quarter, the stock market has rebounded sharply and now sits confidently just below the all-time highs of September 2018. However, a closer look at the entrails of the stock market tells a different story. Since the end of August 2018, cyclically-sensitive stocks such as energy, financials, and materials all remain down by roughly 10% while defensive sectors such as Utilities, Staples and Real Estate are up by 7%.

2. Bond markets around the world are signaling concern as yields are falling and curves are inverting (a historically durable sign of economic slowdown). The amount of negative yielding bonds globally has risen dramatically from less than $6 trillion to over $10.5 trillion since October 2018. Since March 1, 2019, 2-year U.S. Treasury yields have dropped by 35 basis points (bps), and 10-year Treasury yields have fallen by 40 bps (a basis point is 1/100th of a percent). 2-year Treasury yields (2.20%) are now 0.30% less than the upper-bound of the Fed Funds target rate of 2.50%. Meanwhile, three-month Treasury-bill yields are higher than every other Treasury yield out to the 10-year yield. This inversion signals acute worry about an economic slowdown.

3. Economic data in the United States has been disappointing for the balance of 2019. February’s labor market added just 20,000 new jobs compared with an average of +234,000 over the prior 12months. This was the first month under +100,000 since September 2017. Auto sales (-0.8%) were a dud and consumer confidence, besides being down 7 points, saw the sharpest decline in the jobs component since the late innings of the financial crisis (Feb 2009), reinforcing concerns in the labor market. Retail sales and the Johnson Redbook retail data also confirm a slowing/weakening trend in consumer spending. Lastly, as we pointed out at RIA Pro, tax receipt growth is declining. Not what one would expect in a robust economy.

4. As challenging as that list of issues is for the domestic economy, things are even more troubling on a global basis. The slowdown in China persists and is occurring amid their on-going efforts to stimulate the economy (once again). China’s debt-to-GDP ratio has risen from 150% to 250% over the past ten years, and according to the Wall Street Journal, the credit multiplier is weakening. Whereas 1 yuan of credit financing used to produce 3.5 yuan of growth, 1 yuan of credit now only produces 1 yuan of growth. In the European Union, a recession seems inevitable as Germany and other countries in the EU stumble. The European Central Bank recently cut the growth outlook from 1.9% to 1.1% and, like the Fed, dramatically softened their policy language. Turbulence in Turkey is taking center stage again as elections approach. Offshore overnight financing rates recently hit 1,350% as the Turkish government intervened to restrict the outflow of funds to paper over their use of government reserves to prop up the currency.

5. The Federal Reserve (and many other central banks) has formalized the move to a much more dovish stance in the first quarter. On the one hand applauding the strength and durability of the U.S. economy as well as the outlook, they at the same time flipped from a posture of 2-3 rate hikes in 2019 to zero. This shift included hidden lingo in the recent FOMC statement that appears to defy their superficial optimism. The jargon memorialized in the FOMC statement includes a clear signal that the next rate move could just as easily be a cut as a hike. Besides the dramatic shift in rate expectations, the Fed also downgraded their outlook for growth in 2019 and 2020 and cut their expectations for unemployment and inflation (their two mandates). Finally, in addition to all of that, they formalized plans to halt balance sheet reductions. The market is now implying the Fed Funds rate will be cut to 2.07% by January 2020.

Summary

Based on the radical changes we have seen from the central bankers and the economic data over the past six months, it does not seem to be unreasonable to say that the Fed has sent the clearest signal of all. The questions we ask when trying to understand the difference between actions and words is, “What do they know that we do not”? Connecting those dots allows us to reconcile the difference between what appears to be an inconsistent message and the reality of what is written between the lines. The Fed is trying to put a happy face on evolving circumstances, but you can’t make a silk purse out of a sow’s ear.

The economic cycle appears to be in the midst of a transition. This surprisingly long expansion will eventually end as all others have. A recession is out there, and it will make an appearance. Our job is not guessing to be lucky; it is to be astute and play the odds.

Reality reveals itself one moment at a time as does fallacy. Understanding the difference between the two is often difficult, which brings us back to limiting mistakes. Using common sense and avoiding the emotion of markets dramatically raises one’s ability “to be consistently not stupid.” A lofty goal indeed.

Videocast- Has The Cycle Reached Its Tail?

On March 20th we published Has This Cycle Reached Its Tail? With the help of a badly drawn bird, the article described the economic and market cycle of the last ten years. Through an understanding of cycles and importantly, where we are in within a cycle, investors are provided clues on how to position our portfolios for what the cycle has in store.

We believe the current economic cycle is close to a turning point. This is incredibly important to managing wealth, as such we produced the following video that dives further into cycles.

View Part 1

View Part 2

Has This Cycle Reached Its Tail?

We asked a few friends what the picture below looks like, and most told us they saw a badly drawn bird with a wide open beak. Based on the photograph below our colorful bird, they might be on to something. 

As you might suspect, this article is not about our ability to graph a bird using Excel. The graph represents the current bull market and economic cycle as told by the yield curve and investor sentiment.

As the picture is almost complete, the bird provides a clue to where we are in the current cycle and when the next cycle may begin. For investors, one of the most important pieces of information is understanding where we are in the economic cycle as it offers a critical gauge in risk-taking.

Cycles

Economic Cycles- Economic cycles are frequently depicted with a sine wave gyrating above and below a longer-term trend line. Throughout history, economic cycles include periods where economic growth exceeds its potential as well as the inevitable busts when slower than potential growth occurs.  Most often cycles track a trend line, oscillating above and below it, but spend little time at the trend other than passing through it.

Boom and bust periods occur because economic activity is governed by human behavior. In other words, our spending habits are erratic because we are subject to bouts of optimism and pessimism about the economy, our financial prospects and a host of other non-financial issues.

The graph below shows the sine wave-like quality of U.S. GDP growth, which has wavered above and below trend growth for decades. 

Data Courtesy: St. Louis Federal Reserve (FRED)

Stock Market Cycles- Stock markets also follow a pattern that is well correlated to economic cycles. Strong economic activity results in investor optimism. During these periods, investors tend to believe that rising economic growth and strong corporate profits are long-lasting. As such they are prone to extrapolate these shorter-term trends over longer periods. Investors temporarily forget that periods of above-average growth will inevitably be met with periods of below-average growth. During bust periods, these mistakes are corrected and often over-corrected.

Implied volatility is a great measure of aggregate investor sentiment. It measures the expected market movement as determined by the supply and demand for options. When investors are optimistic about future returns, they tend to neglect to hedge in the options market. The sustained and methodical reduction in options pricing causes implied volatility to decline. In recent years, ETF’s and professional strategies whose objectives were to be short volatility steadily gained in popularity and helped push implied volatility down. Conversely, when investors grow concerned over higher valuations, they hedge more frequently using options and drive implied volatility higher.

Yield Curve Cycles- The yield curve also takes on a similar path that tends to mirror economic cycles. When the economic cycle portends strong growth, the yield curve steepens. That is to say, the difference between longer and shorter maturity yields rises. This occurs as investors in longer maturity bonds become increasingly concerned with the potential for rising inflation resulting from stronger economic growth.

When strong growth spurs inflation expectations or actual inflation rises, the Fed begins to take action. To combat rising price expectations, they tighten policy with a higher Fed Funds rate. Shorter-term bond yields follow the Fed Funds rate closely, and as the Fed tries to dampen growth, the yield curve flattens. In that instance, longer-term investors are comforted by the Fed actions. This causes longer maturity yields to rise by less than those of shorter maturity yields, or it can help push longer maturity yields lower on an outright basis.

A steeper yield curve increases the incentive to lend and generates more economic growth while a flatter curve reduces the incentive and slows economic growth. The graph below shows how an inverted yield curve, where the yield on a  2-year U.S Treasury note is higher than that of a 10-year U.S. Treasury note, has paved the way for every recession since at least 1980.

Data Courtesy: St. Louis Federal Reserve (FRED)

The Bird is the Word

The graph below shows a scatter plot of the relationship between implied volatility as represented by spot VIX and the 3-month to 10-year yield curve spread. With proper context, you can see the bird is a graph depicting the most recent cycle of stock market optimism (VIX) and the economic growth cycle (yield curve). The graph uses monthly periods encompassing two -year averages to smooth the data and make the longer-term trends more apparent.

Data Courtesy: St. Louis Federal Reserve (FRED)

When we started on this project, we expected to see an oval shaped figure, slanting upward and to the right. Despite the irregularities of the “beak” and “front legs,” that is essentially what we got.

The blue triangle on the bottom-left is the first data point, representing the average VIX and yield curve spread from January 2006 through December of 2007. The years 2006 and 2007 were the economic peak of the prior market cycle. As shown, the two-year average progresses forward month-by-month and moves upward and to the right, meaning that VIX was increasing while the yield curve was steepening. In this period, the yield curve steepened as the Fed began rapidly reducing the fed funds rate in mid-2007. Likewise, VIX started spiking thereafter as the recession and financial crisis began to play out.

The gray and yellow segments on the graph reflect the decline in volatility as the financial crisis abated. Since 2010, the yield curve steadily flattened, and volatility fell to record lows. The one real break to the cycle trend was the “bird leg,” or the periods including 2013 when the yield curve steepened amid the taper tantrum. After that period, the oval-cycle pattern resumed. The red circle marks the most recent monthly data points and shows us where the trend is headed.

Interestingly, note that the number of dots forming the belly of the bird is much greater than those forming the back. This is typical as the expansionary portion of economic and market cycles tend to last five to ten years while market declines and recessions are usually limited to two or three years.

Summary

Think of the economy and stock market as a long-distance runner. At times they may pick up the pace for an extended period, but in doing so, they will inevitably overexert themselves and then must spend a period of time running at a below average pace. 

The stock market has been outrunning economic growth for a long time. This is witnessed by valuations that have surged to record highs. The yield curve is quite flat and volatility, despite spiking twice over the last year, currently resides well below the long-term average and not far from record lows. The current trajectory, as shown with the dotted red arrow in the chart above, is on a path towards the peak of the prior cycle.

The Fed has recently made a dovish (no pun intended) policy U-turn and appears to be on the path to lower rates. This likely means that the curve flattening is nearing an end and steepening is in the cards. At the same time, the market is showing signs of topping as witnessed by two large drawdowns and spikes in implied volatility over the last 15 months.

Based on the analysis above, it appears that the current cycle is close to completion. It is, however, but one piece of information. To borrow from Howard Marks, author of the book Mastering Market Cycles, he states the following:

While they may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle….there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent.  All we can do is assemble anecdotal evidence and try to draw the correct inferences from it.

We concur and will use the “bird” as evidence that the cycle is mature.

Yesterday’s Perfect Recession Warning May Be Failing You

Recently, Wall Street and the Financial Media have brought much attention to the flattening and possible inversion of the U.S. Treasury yield curve.  Given the fact that an inversion of the 2s/10s Treasury yield curve has predicted every recession over the last forty years, it is no wonder that the topic grows in stature as the difference between the 2-year Treasury yield and the 10-year Treasury yield approaches zero. Unfortunately, much of the discussion on the yield curve seems to over-emphasize whether or not the slope of the curve will invert.  Waiting on this arbitrary event may cause investors to miss a very important recession signal.

The Incentive to Lend

A friend approaches you and asks for a loan. You are presented two options, lend her money for two years at 2% annually or for ten years at the same 2% annual rate.

Later that day, another friend approaches you for a loan. This time you have the option of lending money for two years at 2% or for ten years at 6% annually.

For the lender/investor in both cases, we will ignore inflation risk and assume the two borrowers are in similar financial circumstances. Given the options, you likely answered that if you were forced to lend in example one, it would be only for two years as lending for ten years produced no additional financial incentive to compensate for the additional eight years of risk. Keep in mind most of us would not lend for two years either due to the low-interest rate.

In example two, you may have been incentivized by the higher ten-year interest rate the borrower was willing to pay you. In example one, the “yield curve” is flat at 2%. In example two it is considerably steeper as 10-year “yields” are 4% higher than 2-year yields.

As portrayed, when investors are faced with a flat or inverted yield curve, their incentive to lend for longer terms is greatly diminished. The opposite holds when the yield curve is steeper as in the second example. Taking this one step further, when the absolute level of yields is very low, the incentive to lend, irrespective of the slope of the curve, is also greatly diminished.

When lenders have no financial incentive to extend credit, economies dependent on ever-increasing amounts of credit tend to struggle.

 Yield Curve Predictive History

The graph below plainly shows that when 2-year Treasury yields exceed 10-year Treasury yields, otherwise known as “a curve inversion,” a recession has always followed. Following the inflection point of the inversion, as circled, the curve steepens through a recession and for some time afterward.

Data Courtesy St. Louis Federal Reserve

Given the curve is approaching the inversion point (black line), this compelling evidence is supposed to convince us that the odds of a recession are currently increasing but, and this is important, a recession is not a foregone conclusion yet. While a solid argument based on history, it rests on the theory that there will not be a recession unless 10-year yields drop below 2-year yields (black horizontal line in the graph).

There is another significant trend in the graph, which has gone largely unrecognized. The table below shows the lowest readings of the 2s/10s curve occurring before each of the last five recessions. It is the point of maximum curve inversion for each cycle.

As shown, the magnitude of the greatest yield curve inversion has steadily declined in each of the past five pre-recession episodes.

Increasing Debt Burden and Tight Lending Conditions

The graph below compares total domestic Debt and GDP.

Data Courtesy St. Louis Federal Reserve and Bloomberg

The graph highlights that debt is growing faster than GDP, with GDP representing our collective ability to service repay our debt. In this situation, it takes increasingly greater amounts of debt and lower interest rates to service the existing debt as well as generate new economic activity.

With this troubling dynamic in mind, think back to the two lending propositions we presented earlier. As the yield curve flattens and, by default, lenders are less likely to lend money and economic activity so dependent on that lending activity, slows.

If you accept that line of reasoning, then you must also agree that economies with larger debt burdens are more sensitive to a tightening of financial conditions. Taking it one step further, the amount of inversion required to generate a recession in such a scenario also declines. Might we now be at the point where inversion is not required, and a flat enough yield curve will hamper borrowing and stymie economic activity?

Summary

Based on history, one may deduce that if the curve were to steepen from this point, the odds of a recession decline. We strongly disagree. Given the incremental debt accumulation that has occurred as compared to the accumulation before those five prior episodes, financial conditions have more than likely already tightened enough to induce a recession. The recent steepening of the curve, which might be misinterpreted as a relief, is a flashing red signal that a recession is still very much possible.

For those of you that are stubborn and waiting on the curve to go to zero to sound the recession warnings, we share the graph below, courtesy of Crescat Capital LLC.

The graph looks at numerous yield curves and computes the percentage of them that were inverted at various points of time. Note that about 40% of curves are currently inverted. Have the collective curves already sounded the alarm, but everyone is too focused on a flat 2s/10s curve to hear it?

You Have A “Trading” Problem – 10 Steps To Fix It

In April of 2018, I wrote an article entitled “10-Reasons The Bull Market Ended In 2018” in which I concluded:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a ‘panic selling’ situation.)

If I am wrong, and the bull market resumes, we simply remove hedges and reallocate equity exposure.

‘There is little risk, in managing risk.’

The end of bull markets can only be verified well after the fact, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.”

It is important to remember, that “Risk” is simply the function of how much you will lose when you are wrong in your assumptions.

2018 has been a year of predictions gone horribly wrong.

Not surprisingly, after a decade-long bull market, individuals who were betting on a more positive outcome this year are now clinging to “hope.”

Do you remember all of the analysis about how:

  • Rate hikes won’t matter
  • Surging earnings due to tax cuts will power the market higher
  • Valuations are reasonable

These were all issues which we have heavily questioned over the last couple of years.

And the majority of our warnings “fell on deaf ears” as just being simply “bearish.” 

Of course, you really can’t blame the average investor for ignoring fundamental realities considering they have been repeatedly told the stock market is a “sure thing.” Just “buy and hold” and the market will return 10% a year just as it has over the last 100 years.

This fallacy has been so repeatedly espoused by pundits, brokers, financial advisors, and the media that it has become accepted as “truth.”

But, if it were true, then explain why roughly 80% of Americans, according to numerous surveys, have less than one years salary saved up on average? Furthermore, no one who simply bought and held the S&P 500 has ever lost money over a 10- or 20-year time span. Right? 

Not exactly.

Here is the problem.

No matter how resolute people think they are about buying and holding, they usually fall into the same old emotional pattern of “buying high” and “selling low.”

Investors are human beings. As such, we gravitate towards what feels good and we seek to avoid pain. When things are euphoric in the market, typically at the top of a long bull market, we buy when we should be selling. When things are painful, at the end of a bear market, we sell when we should be buying.

In fact, it’s usually the final capitulation of the last remaining “holders” that sets up the end of the bear market and the start of a new bull market. As Sy Harding says in his excellent book “Riding The Bear:” 

“No such creature as a ‘buy and hold’ investor ever emerged from the other side of the subsequent bear market.”

Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10%, (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experience net outflows of investor money. To wit:

“Lipper also found the largest outflows on record from stocks ($46BN)the largest outflows since December 2015 from taxable bond ($13.4BN) and Investment Grade bond ($3.7BN) funds, and the 4th consecutive week of outflows from high yield bonds ($2.1BN), offset by a panic rush into cash as money market funds attracted over $81BN in inflows, the largest inflow on record.”

“Fear is a stronger emotion than greed.”

Most bear markets last for months (the norm), or even years (both the 1929 and 1966 bear markets), and one can see how the torture of losing money week after week, month after month, would wear down even the most determined “buy and hold” investor.

But the average investor’s pain threshold is a lot lower than that. The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

So THAT is how it happens.

And the only way to avoid it – is to avoid owning stocks during bear markets. If you try to ride them out, odds are you’ll fail. And if you believe that we are in a “New Era,” and that bear markets are a thing of the past, your next of kin will have our sympathies.

But you can do something about it.

Just like any “detox” program, these are the steps to follow to becoming a better long-term investor.

10-Step Process To Curing The Addiction

STEP 1: Admitting there is a problem 

The first step in solving any problem is to realize that you have a “trading” problem. Be willing to take the steps necessary to remedy the situation

STEP 2: You are where you are

It doesn’t matter what your portfolio was in March of 2000, March of 2009, or last Friday.  Your portfolio value is exactly what it is, rather it is realized or unrealized. The loss is already lost, and understanding that will help you come to grips with needing to make a change. Open those statements and look at them – shock therapy is usually effective in bringing about awareness.

STEP 3:  You are not a loser

Most people have a tendency to believe that if they “sell a loser,” then they are a “loser” by extension. They try to ignore the situation, or hide the fact they lost money, which in turn causes more mistakes. This only exacerbates the entire problem until they then try to assign blame to anyone and anything else.

You are not a loser. You made an investment mistake. You lost money. 

It has happened to every person that has ever invested in the stock market, and there are many others who lost more than you.

STEP 4:  Accept responsibility

In order to begin the repair process, you must accept responsibility for your situation. It is not the market’s fault. It is not your advisor’s or money manager’s fault, nor is it the fault of Wall Street. 

It is your fault.

Once you accept that it is your fault and begin fixing the problem, rather than postponing the inevitable and suffering further consequences of inaction, only then can you begin to move forward.

STEP 5:  Understand that markets change

Markets change due to a huge variety of factors from interest rates to currency risks, political events, to geo-economic challenges.

If this is a true statement, then how does it make sense to buy and hold?

If markets are in a constant state of flux, and your portfolio remains in a constant state, then the law of change must apply: 

The law of change:  Change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change. 

Therefore, if you are a buy and hold investor then you have to modify and adapt to an ever-changing environment or you will become extinct.

STEP 6:  Ask for help

This market has baffled, and confused, even the best of investors and will likely continue to do so for a while. So, what chance do you have doing it on your own?

Don’t be afraid to ask, or get help, if you need it. This is no longer a market which will forgive mistakes easily and while you may pay a little for getting help, a helping hand may keep you from making more costly investment mistakes in the future.

STEP 7:  Make change gradually

No one said that change was going to easy or painless. Going against every age-old philosophy and piece of advice you have ever been given about investing is tough, confusing and froth with doubt.

However, make changes gradually at first – test the waters and measure the results. For example, sell the positions that are smallest in size with the greatest loss. You will make no noticeable change in the portfolio right away, but it will make you realize that you can actually execute a sell order without suffering a negative consequence.

Gradually work your way through the portfolio on rallies and cleanse the portfolio of the evil seeds of greed that now populate it, and replace them with a garden of investments that will flourish over time.

STEP 8:  Develop a strategy 

Now that you have cleaned everything up you should be feeling a lot more in control of your portfolio and your investments. Now you are ready to start moving forward in the development of a goal-based investment strategy.

If your portfolio is a hodge-podge of investments, then how do you know whether or not your portfolio will generate the return you need to meet your goals. A goal-based investment strategy builds the portfolio to match investments, and investment vehicles, in an orderly structure to deliver the returns necessary with the least amount of risk possible. Ditch the benchmark index and measure your progress against your investment destination instead.

STEP 9:  Learn it. Live it. Love it.

Once you have designed the strategy, including monthly contributions to the plan, it is time to implement it. This is where the work truly begins.

  • You must learn the plan inside and out so every move you make has a reason and a purpose. 
  • You must live the plan so that adjustments are made to the plan, and the investments, to match performance, time and value horizons.
  • Finally, you must love the plan so that you believe in it and will not deviate from it. 

It must become a part of your daily life, otherwise, it will be sacrificed for whims and moments of weakness.

STEP 10:  Live your life 

That’s it.

You are in control of your situation rather than the situation controlling you.

The markets will continue to remain volatile as a more important “bear market” takes hold in the next year or so.

The good news is that there will be lots of opportunities to make money along the way.

But that is just how it works. As long as you work your plan, the plan will work for you, and you will reach your goals…eventually.

There is no “get rich quick” plan.

So, live your life, enjoy your family, and do whatever it is that you do best. Most importantly, make your portfolio work as hard for you as you did for the money you put into it.

Did The Market Miss Powell’s Real Message?

Last week, I discussed the recent message from Fed Chairman Jerome Powell which sent the markets surging higher.

“During his speech, Powell took to a different tone than seen previously and specifically when he stated that current rates are ‘just below’ the range of estimates for a ‘neutral rate.’ This is a sharply different tone than seen previously when he suggested that a “neutral rate” was still a long way off.

Importantly, while the market surged higher after the comments on the suggestion the Fed was close to ‘being done’ hiking rates, it also suggests the outlook for inflation and economic growth has fallen. With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a ‘neutral rate,’ it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.”

Since then, the bond market has picked up on that realization as the yield has flattened considerably over the last few days as the 10-year interest rate broke back below the 3% mark. The chart below shows the difference between the 2-year and the 10-year interest rate.

Now, there are many who continue to suggest “this time is different” and an inverted yield curve is not signaling a recession, and Jerome Powell’s recent comments are “in line” with a “Goldilocks economy.”

Maybe.

But historically speaking, while an inversion of the yield curve may not “immediately” coincide with a recessionary onset, given its relationship to economic activity it is likely a “foolish bet” to suggest it won’t. A quick trip though the Fed’s rate hiking history and “soft landing” scenarios give you some clue as to their success.

While the Fed has been acting on previously strong inflationary data due to surging oil prices, the real long-term drivers of inflation pressures weren’t present. I have commented on this previously, but Kevin Giddis from Raymond James had a good note on this:

“We have always known that the bond market wasn’t as worried about inflation as the Fed, but it really needed the Fed to come out and indicate a ‘shift’ in that way of thought to seal the deal.”

This is exactly correct, and despite the many arguments to the contrary we have repeatedly stated the rise in interest rates was a temporary phenomenon as “rates impact real economic activity.” The “real economy,” due to a surge in debt-financed activity, was not nearly strong enough to withstand substantially higher rates. Of course, such has become readily apparent in the recent housing and auto sales data.

Flat As A Pancake

All of sudden, the bond market has woken up to reality after a year-long slumber. The current spread between the 2-year note and the 10-year note is as tight as it has been in many years and has rarely occurred when the economic fundamentals were as strong as many believe.

The reality, of course, is much of the current strength in economic activity is not from organic inputs in a consumer-driven economy, but rather from one-off impacts of several natural disasters, a surge in consumer debt, and a massive surge in deficit spending. To wit:

“The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth. Over the long-term, debt leads to economic suppression. Currently, the deficit is rapidly approaching $1 Trillion, and will exceed that level in 2019, which will require further increases in the national debt.”

“There is a limited ability to issue debt to pay for excess spending. The problem with running a $1 Trillion deficit during an economic expansion is that it reduces the effectiveness of that tool during the next recession.”

Our assessment of Powell’s change in tone comes from the message the bond market is sending about the risk to the economy. Since economic data is revised in arrears, the onset of a recession will likely surprise most economists when they learn about it “after the fact.”  Let’s go back to Kevin:

“Here is what we know right now:

1) The U.S. economy seems to be slowing, falling under the weight of higher borrowing costs. What’s hard to predict is whether this is a trend change or a temporary pause.

2) The Fed appeared to blink last week, but we won’t know for sure until December 19th when they release their Rate Decision and ‘tell’ the market what the forward-looking path looks like to them.

3) Inflation is well-contained. For all of you who left town riding on the ‘inflation train,’ welcome back.

4) Global economies are weakening and could get weaker.

5) Friday’s release of the Employment Report should give the market guidance on wages, but not much else.

Kevin is correct, take a look at inflation breakeven rates.

It is quite likely these are not temporary stumbles, but rather a more important change in the previous trends. More importantly, the “global weakness” has continued to accelerate and given that roughly 40% of corporate profits are driven by exports, this does not bode well for extremely lofty earnings forecasts going into 2019.

What Powell Really Said

Caroline Baum had an interesting comment on MarketWatch on Tuesday morning:

“I read with interest the articles last week about the Federal Reserve’s new “unpredictable” and “flexible” approach to monetary policy. No longer can financial markets rely on the gradual, premeditated and practically pre-announced adjustments to the benchmark overnight interest rate, according to these analyses. From now on, the Fed will be ‘data dependent.’”

The whole article is worth a read, but the point being made is that the Fed has always been “data dependent” even if their ability to read and interpret the data has been somewhat flawed. The table below is the average range of their predictions for GDP they publish each quarter versus what really happened.

As Caroline noted, the September projections pegged the “neutral rate” range at 2.5-3.5% with a median estimate of 3%. If Powell is indeed suggesting that the neutral rate has fallen to the low-end of that range, he is likely only confirming what the “yield curve” has been telling us for months. As I quoted previously:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.” 

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting that Powell may have “woken up to smell the coffee.” While the curve is not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker much of the mainstream economists suggests. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q4.)

Mr. Powell most likely also realizes that continuing to tighten monetary policy will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The only question is the timing.

There are currently too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.

As I discussed previously, the stock market is a strong leading indicator of economic turns and the turmoil this year may be signaling just that.

Believing that professional investors will simply ignore the weight of evidence to contrary in the “hopes” this “might” be different this time is not a good bet as “risk-based” investors will likely act sooner, rather than later. Of course, the contraction in liquidity causes the decline in asset prices which will contribute to the economic contraction as consumer confidence is shattered. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become “obvious” the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the “yield curve” as a “market timing” tool, it is just as unwise to completely dismiss the message it is currently sending.

Don’t Fear The Yield Curve?

In July of this year, James McCusker penned an article entitled “Don’t Fear The Yield Curve” in which he stated:

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.”

I didn’t think much of the article at the time as it was an outlier. However, now, given the yield curve continues to trail lower, despite the many calls of “bond bears” swearing rates are going to rise, the number of voices in the “this time is different” camp has grown.

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,”Ryan Detrick, LPL

“In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

First, the yield curve is simply the difference in the yields of different maturities of bonds. However, in this particular case, we are discussing the difference between the 2-year and the 10-year rate on U.S. Treasury bonds.

Historically speaking, the yield curve has been a consistent predictor of weaker economic times in the U.S. As James noted:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.” 

James did hit on an important point but misses the mark.

“Much of our economy relies on debt, and the so-called ‘entitlement’ sector of government spending is dependent on investors parting with cash to purchase trillions of dollars of the federal government’s debt. That means that the investor expectations reflected in the yield curve have some weight. However, it is good to remember that the negative yield curve may simply be the result of a delayed reaction of long-term interest rates to the economy’s expansion. If long-term rates were to rise, the inversion of the yield curve would disappear.”

He is right that we are in a debt-driven economy. Corporate, household, margin, student, and government debt are at all- time highs. That debt has a cost. It must be serviced. Therefore, as rates rise, the cost of servicing rises commensurately. This is particularly the case with variable rate, credit card, and other debt which are tied directly to short-term rates which is impacted by changes in the overnight lending rates (aka Fed monetary policy).

As rates rise on the short-end, and as expected rates of future returns fall, money is shifted toward the “safety” of longer-dated U.S. Treasuries not only by domestic investors, but also foreign investors which are seeking safety from a stronger dollar, weaker economic growth, or reduced financial market expectations.

While there are many calls to ignore the yield curve, some of the most economically sensitive commodities. like Copper, are providing a cause for concern. Per Jesse Colombo: 

“Copper, which is known as “the metal with a PhD in economics” due to its historic tendency to lead the global economy, is down nearly 4 percent today alone and 22 percent since early-June. Copper’s bear market of the past couple of months is worrisome because it signals that a global economic slowdown is likely ahead.”

Copper Daily Chart

Even exports from South Korea, which acts as a leading indicator of economic activity has turned sharply lower as well.

While “sentiment” data was previously extremely elevated over “hopes” that “Trumponics” would create an broad-based economic surge, as noted recently, such has not been the case and “sentiment” is now catching “down” with reality.

Of course, one really needs to look no further than the bond market which is also screaming the Fed is once again, as they always have, making a monetary policy mistake. The chart below shows, GDP as compared to both the 5- and 10-year inflation “breakeven” rates. As noted, there was a significant boost to economic activity following three massive hurricanes and two major wildfires in 2017. That bump to activity only served to “pull forward” future economic activity, increasing short-term inflationary pressures, which are now beginning to subside.

The message is quite simple.

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Furthermore, the AAA-Junk yield curve is also beginning to suggest problems for companies which have binged on debt issuance to support share buybacks over the last decade.

The annual rate of change for bank loans and leases as well has residential homes loans have all started declined as higher rates are crimping demand.

While none of this suggests a problem is imminent, nor does it RULE OUT higher highs in the markets first, there is mounting evidence the Fed is headed towards making another mistake in their long line of creating “boom/bust” cycles.

Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession.

The Federal Reserve is quickly becoming trapped by its own “data-dependent” analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators have been suggesting something very different. This is why the scrapped their Labor Market Conditions Index and are now trying to come up with a “new and improved” yield curve to support their narrative. 

Tightening monetary policy further will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The only question is the timing.

It is unlikely this time is different. There are too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.

Believing that investors will simply ignore the weight of evidence to contrary in the “hopes” this “might” be different this time is not a good bet. The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that “risk-based” investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become “obvious” the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the “yield curve” as a “market timing” tool, it is just as unwise to completely dismiss the message it is currently sending.

The Risk To Markets – Global Growth

The stock market has been rallying on the surge in global economic growth (recently monikered global synchronized growth) over the past year. The hope, as always, is that growth is finally here to stay. The surge in growth has also given cover to the Federal Reserve, and Central Banks globally, to start reducing the flood of liquidity that has been propping up markets globally since the “financial crisis.”

That optimism has bled over in recent months as improving confidence has pushed leverage back to record levels, investors carry the highest levels of risk assets since the turn of the century, and yield spreads remain near record lows. It certainly seems as “things are as good as they can get.”

But it is when things are “as good as they can get” that we find the rest of the story.

recent report from the Brookings Institute highlights one of the biggest risks to investors currently – global growth.

“The world economy’s growth momentum remains strong but is leveling off as the winds of a trade war, geopolitical risks, domestic political fractures, and debt-related risks loom, with financial markets already reflecting mounting vulnerabilities. The latest update of the Brookings-Financial Times TIGER index provides grounds for optimism about the current state of the world economy matched by some pessimism about the sustainability of the growth momentum.”

This has been a key concern of mine of the last several months. The recent uptick in the U.S. economy has been undeniably the strongest we have seen in the last few years. As Brookings notes:

The U.S. economy remains in robust shape, with growth in GDP, industrial production, and investment holding up well. In tandem with strong consumer confidence and employment growth, wage and inflationary pressures have picked up slightly, although less than would be typical at this stage of the cycle.

The issue, however, is that much of that uptick was attributable to a series of natural disasters in 2017. To wit:

“The Trump Administration has taken a LOT of credit for the recent bumps in economic growth. We have warned this was not only dangerous, credibility-wise, but also an anomaly due to three massive hurricanes and two major wildfires that had the ‘broken window’ fallacy working overtime.”

As shown in the chart below, the ECRI’s index and the Chicago Fed National Activity Index suggests that bump in growth may be waning. Historically, spikes in activity have historically noted peaks in the economic cycle. Such should not be surprising as growth breeds optimism which drives activity. Just remember, everything cycles.

While current optimism is high, it is also fragile.

For investors, when things are “as good as they can get,” that is the point where something has historically gone wrong. It is always an unexpected, unanticipated event that causes a revulsion of risk assets across markets. Currently, there are a host of competing forces at play within the markets and the economy. These competing forces weave a delicate balance that can be easily disrupted creating a reversion in behaviors.

As Brookings notes:

The U.S. is engaged in a perilous macroeconomic experiment, with the injection of a significant fiscal stimulus even as the economy appears to be operating at or above its potential. The Fed is likely to lean hard against potential inflationary pressures as this stimulus plays out. Export growth has been buoyed by a weak dollar and strong external demand, but the U.S. trade deficit has still risen over the past year. The large bilateral trade deficit with China remains a flashpoint, setting in motion trade tensions that could have implications for China, the U.S., and the entire world economy.”

But this isn’t just in the U.S. It is also on a global scale.

“In 2017, the Euro-zone turned in its fastest pace of growth over the last decade. Growth in overall GDP as well as in the manufacturing and services sectors remains solid but has cooled off slightly this year. Centrifugal political forces in many countries, rising global trade frictions, and the withdrawal of monetary stimulus could lay bare some of the unresolved structural problems and tensions in the zone.”

The last point was recently noted by Michael Lebowitz:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The central banks’ goals, in general, were threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”– Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.

However, that liquidity support is now being removed.

That extraction of liquidity is potentially already showing up in slower rates of global economic growth. As recently noted by the ECRI:

“Our prediction last year of a global growth downturn was based on our 20-Country Long Leading Index, which, in 2016, foresaw the synchronized global growth upturn that the consensus only started to recognize around the spring of 2017.

With the synchronized global growth upturn in the rearview mirror, the downturn is no longer a forecast, but is now a fact.”

The ECRI goes on to pinpoint the problem facing investors currently which is a “willful blindness” to changes in the economic fabric.

“Still, the groupthink on the synchronized global growth upturn is so pervasive that nobody seemed to notice that South Korea’s GDP contracted in the fourth quarter of 2017, partly due to the biggest drop in its exports in 33 years. And that news came as the country was in the spotlight as host of the winter Olympics.

Because it’s so export-dependent, South Korea is often a canary in the coal mine of global growth. So, when the Asian nation experiences slower growth — let alone negative growth — it’s a yellow flag for the global economy.

The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

While at the headline, things may seem to “firing on all cylinders,” there are many indicators showing rising “economic stress” such as:

The shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment has skewed many of behaviors of politicians, central bankers, and investors. We are currently sailing in very unchartered waters where a single unexpected wave could easily capsize the ship. Not just domestically, but on a global scale.

As Brookings concludes:

“The era of growth fueled by macroeconomic stimulus, with no apparent adverse side effects such as high inflation, appears to be drawing to an end. In the absence of deep-rooted reforms to improve productivity, it will be difficult to ratchet up or even sustain high growth in the major economies.”

Mounting public debt in the U.S. and other advanced economies, compounded by unfavorable demographics, and rising external debt levels of some emerging market economies are risk factors that also reduce policy space for responding to shocks.”

There are a multitude of risks on the horizon, from geopolitical, to fiscal to economic which could easily derail growth if policymakers continue to count on the current momentum continuing indefinitely. The dependency on liquidity, interventions, and debt has displaced fiscal policy that could support longer-term economic resilience.

We are at war with ourselves, not China, and the games being played out by Washington to maintain the status quo is slowly creating the next crisis that won’t be fixed with another monetary bailout.

CBO – “Making America More Indebted”

In December of last year, as Congress voted to pass the “Tax Cut & Jobs Act,” I wrote that without “real and substantive cuts to spending,” the debt and deficits will begin to balloon. At that time, I mapped out the trajectory of the deficit based on the cuts to revenue from lower tax rates and sustained levels of government spending.

Since that writing, the government has now lifted the “debt ceiling” for two years and passed a $1.3 Trillion “omnibus spending bill” to operate the government through the end of September, 2018. Of course, since the government has foregone the required Constitutional process of operating on a budget for the last decade, “continuing resolutions,” or “C.R.s,” will remain the standard operating procedure of managing the country’s finances. This means that spending will continue to grow unchecked into the foreseeable future as C.R.’s increase the previously budgeted spending levels automatically by 8% annually. (Rule of 72 says spending doubles every 9-years) 

The chart below tracks the cumulative increase in “excess” Government spending above revenue collections. Notice the point at which nominal GDP growth stopped rising.

Trillion dollar deficits, of course, are nothing to be excited about as rising debts, and surging deficits, as shown, impede economic growth longer-term as money is diverted from productive investments to debt-service.

While many suggest that “all government spending is good spending,” the reality is that “recycled tax dollars” have a very low, if not negative, “multiplier effect” in the economy. As Dr. Lacy Hunt states:

“The government expenditure multiplier is negative. Based on academic research, the best evidence suggests the multiplier is -0.01, which means that an additional dollar of deficit spending will reduce private GDP by $1.01, resulting in a one-cent decline in real GDP. The deficit spending provides a transitory boost to economic activity, but the initial effect is more than reversed in time. Within no more than three years the economy is worse off on a net basis, with the lagged effects outweighing the initial positive benefit.

Dr. Hunt is absolutely correct when he notes that due to the aging of America, the mandatory components of federal spending will accelerate sharply over the next decade, causing government outlays as a percent of economic activity to move higher. According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

As Dr. Hunt concludes:

“The rising unfunded discretionary and mandatory federal spending will increase the size of the federal sector, which according to first-rate econometric evidence will contract economic activity. Two Swedish econometricians (Andreas Bergh and Magnus Henrekson, The Journal of Economic Surveys (2011)), substantiate that there is a ‘significant negative correlation’ between the size of government and economic growth. Specifically, ‘an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.’ This suggests that if spending increases, the government expenditure multiplier will become more negative over time, serving to confound even more dramatically the policy establishment and the public at large, both of whom appear ready to support increased, but unfunded, federal outlays.”

The evidence is pretty clear.

Trillion Dollar Deficits

The Committee For A Responsible Federal Budget just released the following analysis:

“The Congressional Budget Office (CBO) released its ten-year budget and economic outlook today, showing that recent legislation has made an already challenging fiscal situation much worse. CBO’s report projects that:

  • The budget deficit will near one trillion dollars next year, after which permanent trillion-dollar deficits will emerge and continue indefinitely. Under current law, deficits will rise from $665 billion (3.5 percent of Gross Domestic Product) last year to $1.5 trillion (5.1 percent of GDP) by 2028.
  • As a result of these deficits, debt held by the public will increase by more than $13 trillion over the next decade – from $15.5 trillion today to $28.7 trillion by 2028. Debt as a share of the economy will also rise rapidly, from today’s post-war record of 77 percent of GDP to above 96 percent of GDP by 2028.
  • Cumulative deficits through 2027 are projected to be $1.6 trillion higher than CBO’s last baseline in June 2017. The entirety of this difference is the result of recent legislation, most significantly the 2017 tax law.
  • Spending will increase significantly over the next decade, from 20.8 percent of GDP in 2017 to 23.6 percent by 2028. Revenue will dip from 17.3 percent of GDP in 2017 to 16.5 percent by 2019 before rising to 18.5 percent of GDP by 2028 as numerous temporary tax provisions expire.
  • Deficits and debt would be far higher if Congress extends various temporary policies. Under CBO’s Alternative Fiscal Scenario, where Congress extends expiring tax cuts and continues discretionary spending at its current level, the deficit would eclipse $2.1 trillion in 2028, and debt would reach 105 percent of GDP that year – nearing the record previously set after World War II.

CBO’s latest projections show that recent legislation has made an already challenging fiscal situation much more dire. Under current law, trillion-dollar deficits will return soon and debt will be on course to exceed the size of the economy. Under the Alternative Fiscal Scenario, the country would see the emergence of $2 trillion deficits, and debt would reach an all-time record by 2029.”

This analysis certainly isn’t the policy prescription to “Make America Great Again,” but rather “Make America More Indebted.” 

I encourage you to read the entire analysis by the CRFB, but the bottom line is what we already know, more debt equals less economic growth.

“As a result of this and other effects, CBO estimates real GDP growth of 1.5 to 1.8 percent each year after 2020, with an annual average of 1.8 percent over the 2018-2028 period. This is very similar to the average growth rate projected in June 2017.

Notably, CBO’s projected average growth rate is significantly lower than the roughly 3 percent assumed in the President’s FY 2019 budget. Such rapid levels of growth are far below what others – including the Federal Reserve – have projected; and they are highly unlikely to occur based on available economic evidence. The fact that 3 percent growth could be sustained for two years does not suggest it could be continued indefinitely over the long term.”

As I noted previously, it now requires $3.71 of debt to create $1 of economic growth which will only worsen as the debt continues to expand at the expense of stronger rates of growth.

CBO – Always Wrong

Furthermore, it is highly likely the CBO will be incorrect in their assumptions, as they almost always are, because there are many items the CBO is forced to exclude in its calculations.

First, the CBO’s governing statutes essentially require a distorted view of the finances by not allowing for an accounting of the tax breaks Congress routinely extends. As William Gale from the Tax Policy Institute explained:

“Here’s the bad part:  Under current law, CBO projects that the debt – currently 77 percent as large as annual GDP – will rise to 96 percent of GDP by 2028.  And that’s if Congress does nothing.  If instead, Congress votes to extend expiring tax provisions – such as the many temporary tax cuts in the 2017 tax overhaul – and maintain spending levels enacted in the budget deal (which is called the “current policy” baseline), debt is projected to rise to 105 percent of GDP by 2028, the highest level ever except for one year during World War II (when it was 106 percent).”

So, once you understand what the CBO isn’t allowed to calculate or show, it is not surprising their predictions have consistently overstated reality over time. However, it’s how Congress wants the projections reported so they can continue to ignore their fiscal responsibilities.

This is a big problem which David Stockman, former head of Government Accountability Office, pointed out:

“What that leads to is a veritable fiscal nightmare. Whereas the CBO report already forecasts cumulative deficits of $12.5 trillion during the next decade, you’d get $20 trillion of cumulative deficits if you set aside Rosy Scenario and remove the crooked accounting from the CBO baseline.

In a word, what was a $20 trillion national debt when the Donald arrived in the White House is no longer. Now it’s barreling toward $40 trillion within the next decade.

We have no ideas how much economic carnage that will cause, but we are quite sure it will not make America Great Again.”

However, besides those flaws, the CBO gives no weight to the structural changes which will continue to plague economic growth going forward. The combination of fiscally irresponsible tax cuts combined with:

  • Spending hikes
  • Demographics
  • Surging health care costs
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These factors will continue to send the debt to GDP ratios to record levels. The debt, combined with these numerous challenges, will continue to weigh on economic growth, wages and standards of living into the foreseeable future. As a result, incremental tax and policy changes going forward will have a more muted effect on the economy as well.

Conclusion

The CBO’s latest budget projections confirm what we, and the CRFB, have been warning about. The current Administration has taken a path of fiscal irresponsibility which will take an already dismal fiscal situation and made it worse.

While the previous Administration was continually chastised by “conservative” Republicans for running trillion-dollar deficits, the Republicans have now decided trillion dollar deficits are acceptable.

That is simply hypocritical.

Given the flaws in the CBO’s calculations, their current projections of $1 trillion in deficits next year, and exceeding that mark every year after, will likely turn out to be overly optimistic. Even the CBO’s Alternative Fiscal Scenario of $2 trillion deficits over the next decade could turn out worse.

But William Gale summed up the entirety of the problem nicely.

“Here’s the worse part: The conventional comparison is misleading.  The projected budget deficits in the coming decade are essentially ‘full-employment’ deficits. This is significant because, while budget deficits can be helpful in recessions by providing an economic stimulus, there are good reasons we should be retrenching during good economic times, including the one we are in now. In fact, CBO projects that, over the 2018-2028 period, actual and potential GDP will be equal.

As President Kennedy once said ‘the time to repair the roof is when the sun is shining.’  Instead, we are punching more holes in the fiscal roof. 

In order to do an ‘apples to apples’ comparison, we should compare our projected Federal budget deficits to full employment deficits. From 1965-2017, full employment deficits averaged just 2.3 percent of GDP, far lower than either our current deficit or the ones projected for the future. 

The fact that debt and deficits are rising under conditions of full employment suggests a deeper underlying fiscal problem.”

The CBO’s budget projections are a harsh reminder the fiscal largesse that Congress and the Administration lavished on the country in the recent legislation is not a free lunch.

It is just a function of time until the “bill comes due.”