The recent behaviour of the bond market is making many equity investors nervous that they may be missing something that the bond world is seeing, namely a recession.
Paul Mortimer-Lee, the chief North America economist at BNP-Paribas (via Yahoo Finance, tks Pat) writes:
Bond yields are inherently forward-looking. The bull flattening we have seen is not a good sign, because it signals less faith in future growth and/or inflation prospects. Chart 5 looks at US GDP growth and the shape of the US curve. It seems to suggest a lead of about a year between shifts in the curve and subsequent growth performance (measured year on year). Viewed in this light, the recent flattening of the bond curve looks worrying, since it seems to foreshadow a further slowdown in activity over coming months.
CrystalBull.com, actually a pretty interesting site I discovered thanks to Pat, has this to say about the predictive ability of the yield curve:
Because of the unknowable lag or market response times, Yield Curve studies have been marginally effective in stock market timing systems. But an inverted Yield Curve has been a precursor to 7 of the last 7 recessions. Note that the last Yield Curve inversion was well before the bursting of the housing bubble, the Lehman Brothers bankruptcy, or the stock market crash. The Yield Curve deserves attention from all stock market investors.
Researchers at the NY Fed have a done extensive research on the yield curve. Here’s the important stuff (with a lot more here):
What does the evidence say, in short?
The difference between long-term and short-term interest rates (“the slope of the yield curve” or “the term spread”) has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters. (…) The specific accuracy of these predictions depends on the particular measures employed, as well as on the estimation and prediction periods. However, the results are generally statistically significant and compare favorably with other variables employed as leading indicators. (…) The yield curve has predicted essentially every U.S. recession since 1950 with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom.
What maturity combinations work best?
(…) At the long end, the clear choice seems to be a ten-year rate, which is the longest maturity available in most countries on a consistent basis over a long sample period. At the short end, there is a wider variety of choices. An overnight rate, such as the fed funds rate, is close to the extreme of the maturity spectrum. However, its usefulness as an indicator of market expectations is confounded by its fairly direct control by the Federal Reserve. A common choice currently is the two-year Treasury rate, perhaps because of the liquidity of the associated instruments. Background research in connection with Estrella and Mishkin (1998) suggested that the three-month Treasury rate, when used in combination with the ten-year Treasury rate to predict U.S. recessions, provides a reasonable combination of accuracy and robustness over long time periods. In the end, most term spreads are highly correlated and provide similar information about the real economy, so the particular choices with regard to maturity amount mainly to fine tuning and not to reversal of results. The caveat is that a benchmark that works for one spread may not work for another. For instance, the ten-year minus two-year spread may invert earlier than the ten-year minus three-month spread, which tends to be larger.
Is it the level or the change in the spread that matters?
(…) it is the level of the term spread – not the change – that helps forecast both recessions and changes in real economic activity. For recessions, it is clearly the level that matters. In a probit model of the probability of recession, a given change in the spread can have a very different impact, depending on the initial level of the spread. When the curve is very steep, say the spread is above 300 basis points, a change of 50 basis points in the spread hardly changes the probability of recession. However, if the spread starts out at 50 basis points, a decrease of that magnitude may raise the implied probability by 10 percentage points or more. (…)
Does it matter if changes are driven by the short or the long end?
The best forecast of future real activity is provided by the level of the term spread, not the change in the spread, nor even the source of the change in the spread. Thus, if a low or negative value of the spread is reached via an increase in the short-term rate or a decrease in the long-term rate, it is only the low level that matters. In the six months preceding the trough of each yield curve inversion in the United States since 1960, we see a decline in the ten-year Treasury rate in two of seven cases (before the 1990-1991 and 2001 recessions) and an increase in the other cases. The direction of the change in the ten-year rate at the time of the signal does not appear to be indicative of the strength or duration of the subsequent recession. It is clear, however, that each recessionary episode is preceded (with varying lead times) by a substantial increase in the short-term rate.
Is an inversion required for a signal?
(…) since 1960, a yield curve inversion (as measured by the difference between ten-year and three-month Treasury rates) has preceded every recession on record. In fact, in terms of monthly averages, the ten-year rate was at least 12 basis points below the three-month rate before every recession in that period. In contrast, very low positive levels of the spread have been observed without a subsequent recession. Specifically, there were two episodes in the 1990s in which the term spread attained very low positive levels (42 and 12 basis points respectively), but did not invert. In both of those cases, economic activity continued unabated after the troughs or low points for the spread. Thus, using inversion as a benchmark, there were no “false positives” during the period. While inversions and recessions may not be inevitably connected by theory, they correspond to extreme values of the term spread and output growth, respectively, which are in fact theoretically linked.
My own observations:
- Recessions generally do not happen out of thin air. When alarmed by rising inflationary pressures, the Fed increases short term rates to cool the economy, often triggering a recession in the process.
- The current flattening of the yield curve is nothing extraordinary coming from rather historically extreme levels:
- The current flattening of the curve is essentially caused by declining long rates which, in the U.S., are back to their July 2012 growth scare low (1.51%).
The 2012 growth scare caused a 10.6% equity market correction which has not happened yet in spite of
- pretty lousy economic data from across the world;
- an uncertain, even mystified Fed;
- declining corporate profits;
- uncertain China;
- poor investor sentiment;
- negative equity flows;
- Brexit fears;
- the U.S. elections.
Hubert Marleau, economist at Palos Management and a long-time observer of monetary matters, details some recession indicators and their current readings:
1. The Vanguard proprietary model, which is comprised of 75 active economic indicators, puts the probability of a recession over the next six months at about 10%. That is even though there is a high chance that US job growth is bound to slow down and market volatility bound to increase.
2. Another reliable indicator is the yield curve. It should be noted that it’s not the actual inversion that has the predictive power but the “flattening process”. History shows that 75 bps between the ten-year Treasury yield (1.65%) and Federal funds rate (0.25%) is the trigger point. Should this be correct, the yield on long term treasury notes would need to fall another 65 bps to signal a forthcoming recession.
3. Another preferred measure is the Chicago Fed National Activity Index (CFNAI), It’s made up of four broad and key economic categories of data. Historically, it has done a fine job of signaling an imminent recession. The index does not point to one at this time.
4. Moody’s Analytics has a proprietary High Frequency GDP Model (HMF) that comprehensively estimates the current growth rate and direction of the economy. The HMF model shows that the second quarter R-GDP is now tracking an annual growth rate of 2.4%.
5. The Federal Reserve Bank of Atlanta also has a successful model: “GDPNow”. Of all the trackers that we watch, this one has been outstandingly accurate. On June 14, the model forecasted a real growth rate of 2.8% for the second quarter of 2016.
One could add that equity markets are also not signalling a recession. But equity markets are not always right as Paul Samuelson once said:
To prove that Wall Street is an early omen of movements still to come in GNP, commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.
— “Science and Stocks,” Newsweek, September 1966
Just to say that equities do not necessarily need a recession to correct or morph into a bear.
The reality is that unless the Fed gets into a true tightening mode, recessions cannot be forecast.
But today’s other reality is that the economy is weak enough to be vulnerable to shocks and tilt into a recession on its own. And the list of potential trigger shocks is long and well known, even though possibly not well understood.
At the macro level, it is fair to say that, whether they understand what’s going on or not, central bankers potency has evaporated. Lately, low, lower even negative interest rates are not proving very effective at stimulating the real economy anywhere in the world. Meanwhile, policy makers don’t seem very anxious to use their fiscal toolbox.
At the micro level, corporations are focused on their profitability and cashflows in the face of very low top line growth, rising wages, economic and political uncertainty and elevated debt levels. When not engaged in ZIRP or NIRP facilitated M&A activity, which perversely quickly triggers synergistic behaviors (i.e. costs cutting), companies feel an urgent need to deleverage their cost and financial structures., even more so when hearing the Fed’s desire to raise rates and even more so when seeing the Fed backtrack and look like a drunken sailor trying to find its way to somewhere.
The probabilities of a recession may be fairly low, but the possibilities are nonetheless not trivial.
In this rather risky context of elevated equity valuations and recession possibilities, the risk/reward equation is highly unattractive.