David Roberts

Why markets have been pitched a curveball

David Roberts

The overnight rout in the S&P has been attributed to the stronger labour market data emanating from the US on Friday.  Initial attention was on the strong payrolls number before focus shifted to average hourly earnings which were up 2.9%.  The financial markets are worried that increasing wage inflation will lead the US Federal Reserve to increase the pace of its interest rate rises. Although increases in base rates are very important, in this article David Roberts Head of Global Fixed Income at Liontrust argues that the shape of the yield curve is a superior forecaster of the future.

Bond markets have historically been accurate predictors of recessions six to nine months in advance. What are they currently telling us? And why are some people saying this time could be different? 

After nearly a decade of Central Bank largesse, it seems we are finally moving back to a world of “normal” interest rate policy. I recognise that for anyone under the age of 35, low rates and upward sloping yield curves – where we can lend money for a longer time and get paid more interest in return – are not just logical and obvious, but the only thing they have known throughout their working lives. And an upward sloping curve does tend to prevail, albeit not to the same extent we have seen during a decade of QE (Quantitative Easing) and zero interest rates.


What is changing?

Historically, whenever the US Federal Reserve moves to increase interest rates, to tighten monetary policy, the relationship between different maturities of US Government debt changes. That is, the Treasury yield curve flattens. This means investors are demanding less of a premium or less extra interest to lend to the government for longer periods of time.

Then the curve eventually inverts - we receive more for lending for a short time than we do lending for the longer term. Why? Short dated bonds rise in yield and fall in price because they tend to be very sensitive to changes in the Federal Funds rate. At the same time, investors grow concerned that tighter policy (those higher Fed Funds again) will ultimately choke off growth and inflation, so they are willing to buy long dated bonds for capital gain and protection against economic upset.

This relationship is shown in the chart below. This captures the yield differential for lending to the US Government for either five or 30 years. At present, an investor receives about 0.49% more to lend for the longer term. You can see how much this has collapsed in recent months.


40 years of US interest rates

David Roberts - Markets are pitched a curveball

US 5/30 yield differential: Source Bloomberg


Isn’t curve inversion just an issue for the bond market?

Curve inversion is strongly associated with rising interest rates. It also tends to be an “end of cycle” phenomenon – the last hurrah of economic expansion. So in this regard it is a vital signal for all investors, not just those in fixed income.

As a reminder, in the good times, growth and inflation rise, then the Federal Reserve raises rates, the curve inverts, higher borrowing cuts investment (including in people), this prompts delinquencies and defaults and we hit recession. That’s the bad news.

The good news is there is normally a lag between when the curve inverts and the economy going into recession. Table 1 below shows the time from curve inversion to recession - you can see it can be up to 15 months until GDP troughs. Or it can be immediate.

 

Table 1: Time from inversion to GDP trough

Date curve Inverts

29/6/79

30/9/80

29/6/84

30/12/88

30/3/90

30/12/94

31/12/99

31/3/06

Quarters to GDP trough

1

0

3

5

4

2

2

3

Source: Liontrust/Federal Reserve

It is not just fixed income: risk markets also tend to predict recession. A recent Wells Fargo paper highlighted how different sectors of the US stock market behaved ahead of a growth slowdown. Every sector of the S+P, bar energy, hits a valuation peak well in advance of a recession being called:


Table 2: Months from Peak equity value to recession

 

Material

Con Disc

Financials

Tech

Utilities

Energy

Period

 

 

 

 

 

 

Late 90s

11

11

10

2

7

0

Early 00s

23

15

3

12

3

-2

Late 00s

2

7

7

2

0

-6

Source: Wells Fargo Investment Institute 18th December 2017

Taking these two together: Table 1 suggests the yield curve becomes flat/inverted between six and nine months before recession. Using the full data from the Wells Fargo study, the average S+P sector hits peak value around six months before recession. So, if we assume history repeats itself then the US economy does look like it is entering the danger zone.


Is it different this time?

How I hate the phrase, but yes it may be different this time. Why?

The starting point is that this time around interest rates are much lower than usual. Remember Fed Funds actually hit 20% a couple of decades ago. The cost of borrowing, should the Fed raise a few more times, will still remain well below the average rate for the past 40 years. A key metric for bond managers is how easy it is for companies to service their debt – how many times is interest covered? Even if interest rates double from current levels, in absolute terms they should be manageable for large companies. In counter point, we just don’t know how a generation of US consumers and mortgage owners will fare should rates rise aggressively. We were in a similar situation in 2008 and that didn’t end well.

Second is pace: when the Fed tightens, it tends to do so aggressively. Curve inversion normally follows a three-month period during which rates have moved up at least 1%. We have had five rate rises in two years, totalling 1.25%. This is moderate and at least in part designed not to spook the consuming horses. All things being equal, it is very difficult to envisage our incoming Fed Chair Jerome Powell as being hawkish enough to raise rates more than 1% in the coming 12 months.

Third is fiscal policy. Since the 1950s, one of the first actions of most Western governments to recession was to expand their fiscal base, to try to spend their way out of trouble. Increasingly independent central banks reacted in the only way they could with aggressive monetary policy: 15% UK Base Rate and 20% Fed Funds.

And then we found ourselves in the midst of the GFC – since when we have had 10 years of central government ennui, of austerity in one form or another. Slashing rates, refusing to borrow and wiping out “toxic assets” was painful, but it did see a base reached, a foundation laid for what has been one of the longest periods of expansion in 200 years. Say what you will of Trump, it may be that a Reaganesque tax and spending cut towards the end of a period of growth could materially lengthen the cycle. The devil’s advocate notes we may be forgetting the lesson of 2008: let bad businesses, bad loans fail – to do otherwise simply stores up problems for tomorrow.

Of course, a policy of cutting corporation tax and leaving personal taxation alone could be considered the fiscal equivalent of QE: boosting financial assets and doing precious little for the real economy. A low marginal propensity to consume and low economic multiplier leaves growth and inflation dependent on “trickle down” effects, but it may be great for the stock market!


So, what does all that mean?

The shape of the US Treasury curve tends to be a good predictor of recession in the US and global economy. This curve is starting to signal a recession coming in the next six to nine months. Risk assets, US equities at any rate, see peak valuation five or six months before a recession starts.


And for investors?

I’m laughed at when I talk of recession: QE in Europe still exists, Trump is cutting tax and there are few signs of profit taking en masse. But investors in sovereign debt need to hope the Federal Reserve remains cautious and inflation fails to rise further. This is already looking a difficult year, with many bond hawks, myself included, believing we are at the start of a bear market. Remember the dollar is weaker, commodities are up in value and labour capacity is scant. None of this suggests inflation is falling soon.

If US market rates do move well above 3% (I believe the whole of the US rate curve beyond five-year notes will do so by June), then at this level it starts to look a tentative buy.



Key Risks & Disclaimer

Please remember that past performance is not a guide to future performance and the value of an investment and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital.

This Blog should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust.
Tuesday, February 6, 2018, 10:24 AM