Discretionary Recessionary Signals

Do you feel more optimistic than a year ago? Despite more negative headlines and political turmoil, bond markets are signaling more optimism surrounding future growth than a year ago.


Nominal yields around the world are much much lower than their historical averages. We actually see negative rates in some European nations. That being said, things are improving. Long-term growth expectations are heating up:


Since a year ago (See: Column “Delta One Year”), all yield curves have steepened, with the Italian yield curve steepening the most severely. In all cases, the 10-year yield rose/fell faster/slower than the 2-year yield. This signals more demand for short term bonds compared to a year ago. Since a month ago (See: “Delta One Month”), all yield curves, save for Italy, have flattened. This signifies more demand for long term debt than short term debt. See Table 1:


It seems sentiment has changed since a year ago. Within the last month, more investors have loaded into longer-term fixed income securities. This is a yield-seeking activity. There has been a global flight to longer term, higher yielding fixed income securities within the last month. This point of view describes investors preference for more yield (less long-term risk).

As yields rise, the opportunity cost of owning stocks rises. More investors will flock to bonds as yields become more attractive. This dynamic causes equity markets to follow bond markets. This point of view describes investors preference for more return i.e. more yield.


Dueling Pianos:

As the yield curve steepens, expectations of future long-term growth have risen relative to short-term growth expectations. As investors become more optimistic on the economy, more money will pile into riskier assets, i.e. stocks. I call this the Future Expectations argument. Under this argument, a yield curve steepening results in higher stock prices. This argument describes an investors preference for risk. More expected growth = more willingness to accept risk. Under this argument, bonds and stocks are inversely correlated.

As the yield curve steepens, yields rise and prices fall on the long end of the curve. As yields rise, equity investors looking for yield will sell equities in favor of bonds. As long term yields rise, equities will fall. This is the Opportunity Cost argument. Under this argument, a steepening yield curve will result in lower stock prices. This argument describes an investors preference for yield. Under this argument, bonds and stocks are positively correlated. (For more on Stock/Bond Correlation, see PIMCO).

Given today’s nominal yields & equity values:

Investors are yield-seeking at current nominal yields, thus the Opportunity Cost argument dominates the Future Expectations argument. When the yield curve flattens today, equities will rise tomorrow and when the yield curve steepens today, equities will fall tomorrow. As nominal yields rise, I believe the relationship will flip, and the Future Expectations argument will dominate.

In 12 out of those same 12 markets, yield curves have steepened over the last year. In 11 out of 12 markets in our sample, yield curves have flattened within the last month. Should this change of sentiment continue, yield curves will flatten and equities will continue to rise. However, I expect the long-term trend to prevail, with yield curves continuing to steepen throughout the next year.

When the ECB and BoE decide to stop QE and raise short term rates, I expect yield curves to steepen. As yield curves steepen, equity markets will fall as investors switch to bonds from stocks. Investors will flock to safety, rallying bond markets.

Watch the ECB and BoE for signals on bond markets. See German Bund Yields.

Thanks for reading,

– Tommander-in-Chief

Sauce: http://www.wsj.com/mdc/public/page/2_3022-govtbonds.html

Further: “What the hell are you talking about?”

A common measure of bond market sentiment is the different between the yield on a 10-year government bond and a 2-year government bond. For example, the spread below is 1.25%. (Note: not the actual yield curve below.)


Review: There are two types of yield curve steepeners: Bull and Bear. A bull steepener short term rates are falling faster than long term rates. This means the 2-year fell faster than the 10-year (and both rates fell); recall, prices rise as yields fall. A bond bull market is one where yields fall. A bear steepener is one where the 2-year rises less than the 10-year, and both rates rise. Prices on bonds fall as yields rise.



Why are Markets so Calm?

Valuations are stretched and economic data is cooling, yet markets are complacent. Why? The following are rationalizations of current market values.

1.) Massive movement from active management into passive strategies. Why pay someone to under-perform the S&P 500? Passive investing implies no trading, which means less volatility.

2.) Increased regulation has permanently caused a decline in the riskiness of markets. Insurance companies and financial institutions no longer have autonomy over what they can invest in. With more oversight comes less risk…

3.) Lower interest rates globally have caused investors to flood into riskier assets. With more investors seeking risk, demand is high, creating inflated but stable asset prices. Argentina, who has defaulted on Government debt SEVEN TIMES, just issued a 100-year bond at a 7.9% yield. Demand for the high yielding asset was strong.

4.) JPMorgan estimates that stock pickers account for just 10% of trading volumes, with 60% done by quantitative trading strategies and passive investing. With more trading done by ’emotionless’ quantitative algorithms rather than hot-blooded traders, market risk has declined permanently. We’re in a “new normal” of low volatility and interest rates. Sounds firmiliar… *cough* Tech bubble in 2000 *cough*

5.) “Stocks always go up.” 😉

6.) Quantitative Easing in Europe and Japan cause inflows to higher yielding assets. The Bank of Japan (BOJ) or the European Central Bank (ECB) pumps liquidity into markets through open market operations (bond buying initiatives). Sellers of the bonds use the Yen or Euros to buy US Dollars. They use the Dollars to buy equities and debt. QE by foreign governments is inflating assets prices. As they continue to ease, i.e. flood markets with liquidity, we should see the trend continue. However, we have seen the USD decline since December ’16. Keep an eye on foreign monetary policy moves. A sudden move by the ECB or BOJ might cause fluctuation in US asset prices.

SAUCE: https://www.bloomberg.com/news/articles/2017-06-27/markets-may-have-nothing-left-to-fear-but-fearlessness-itself

Thanks for reading.

– Tommander-in-Chief

Trouble in Yellen-Land

Bond markets and the Fed aren’t making sense.

The Fed (“Yellen”) rose the Federal Funds Rate (FFR) last Wednesday, June 12th to a range of 1.00% to 1.25%.

The Fed has two mandates: (1) to keep prices stable (i.e. keep inflation around 2%) and (2) to minimize unemployment. In other words, stabilize the economy by cooling it off when growth gets too fast and heating the economy up when growth slows.

The mechanisms to do this are two fold. The Fed can raise the “Federal Funds Rate” (FFR), making short term credit less available. The FFR is the lowest rate at which a financial institution can borrow. If you raise the lowest rate available in US markets, everything else should follow. Right?

Wrong. The FFR is a very short term instrument. Changes in the FFR only change short term interest rates. (See: Term Structure of Interest Rates). This brings us to our second weapon in the Fed’s arsenal: the Balance Sheet. The Fed can buy and sell securitized mortgages and government debt. They can hold assets on their balance sheet to synthetically alter the supply of debt at longer tenors.

Quantitative Easing (QE) by the Fed flooded markets with cash by purchasing bonds in the open market in order to promote lending (i.e. liquidity). The Fed’s balance sheet exploded… I mean EXPLODED. Check this post for relativity. In the most recent Fed statement, the Committee agreed it would soon be time to bring the balance sheet back to “normal”. This means they will no longer buy new treasuries or redeem matured securities.

Once balance sheet normalization begins, there will be less demand for Treasuries and yields should rise, ceteris paribus. Right?

However, longer term treasury yields have fallen while short term rates rose. This results in a flatter yield curve. Growth in the US and the world remains tepid; and inflation in the US remains under the 2% target rate, but the Fed sees fit to continue tightening monetary policy.

So what gives Janet? 

This morning, Lisa Shalett, Head of Wealth Management Investment Resources at Morgan Stanley, wrote: “… we believe the Fed has embraced a new narrative that extends beyond its mandate of full employment and 2% target inflation.”

The Fed isn’t raising rates because our economy is heating up; they’re trying to combat the next recession proactively. They’re ‘normalizing’ the FFR and the balance sheet back to levels where they can reasonably combat the next recession.

OK, but why the flatter yield curve?

A colleague of mine introduced the idea of relative interest rates as an additive theory. The risk/reward profile of US debt is one of the best in the world. For example, the 10-year government debt yield in Singapore is comparable to the same rate in the US. Would you rather have Singaporean dollars or US dollars given current market conditions? That being said, we have seen a sell off in the US dollar since the beginning of the year. Take a look at what has happened to the US dollar since President Trump took office:


The dollar has rallied and subsequently sold off since the election. In my colleague’s argument, the dollar should rise. If there is a high demand for Treasury bonds, we will see a rise in demand for dollars. You can’t buy US government debt with foreign currency; you have to convert it to US dollars first. More buying of USD pushes up the price.

The recent bond market rally on the long end of the yield curve has pushed rates lower. This could be from more demand as per my colleague’s point; or the bond market is calling bullsh*t on the Fed’s optimistic outlook for the economy because a movement from stocks into bonds signifies a move to safety. When the 10- to 2-year spread tightens, it signifies lower growth expectations in the future.


When Trump was elected, stock markets rallied. The so called “reflation trade” became all the buzz and a “risk-on” mentality became popular. Check out the pop in the 10 to 2 on November 8-10th. This was a spark of optimism that the US economy might see some fiscal stimulus. Since, the bond market has postulated that the current administration might not be able to meet goals in respect to healthcare and infrastructure stimulus, thus spreads have narrowed and expectations tempered.

To review:

The Fed says we’re growing at a healthy clip, with inflation rising. Their reflation narrative is weak, and the bond market isn’t buying it.The Fed is trying to stockpile ammo before the next recession.

What I’m watching:

An inverted (i.e. negative) 10- to 2-year spread has preceded EVERY recession in recent history. Check it out:


Keep an eye on the 10 to 2.

What I’m Reading:

Thanks for reading,

– Tommander-in-Chief


Disclaimer: there are SO MANY moving parts in finance. It’s impossible to point to any one factor because it’s always a combination of several or many factors that affects markets.