By Emil Emilov
After 5 months in a row of negative returns US equity indices look like they are trying to return to positive territory for October. For the last two weeks the S&P500 returned about 14% from its previous lows of around 1080. The upside pressure has lost some of its steam but is holding steady on positive economic reports in the U.S. and hope out of Europe.
In the US Treasuries markets the situation was somewhat more intense as the 10-year notes yield rose almost 25% since the beginning of October. The increase in 30-year yield amounted to about 16% according to data from the US Department of the Treasury. An article in Bloomberg attributes much of that change to the easing of the concerns on Europe as not being able to handle its debt problems and on some positive US economic data.
Despite how comfortable such events might be for the longs in equities it pays to take things in perspective, try to connect the dots and examine if the situation could really present a long-term opportunity or would happen to be just another "dead cat bounce".
During previous weeks another Bloomberg article presented that bonds were showing a 60% chance of recession in the next 12 months. In such a perspective it seems a bit strange the markets, both equity and bonds, continued to look and act so optimistic. To get a clearer view we’ll first examine the mentioned yield curve and its predicting power.
Since the 1950s the available monthly yield curve data shows that before each of the last seven recessions short-term interest rates rose above the long-term ones. That inverts the yield curve and it happens so that in the next 12 months a recession surely follows. There are various research documents that observe this phenomenon and yet none of them has presented a theory to completely explain the observed correlations. On the Federal Reserve Bank of New York website there is a practical guide by Arturo Estrella and Mary R. Trubin on how to use the yield curve and the spread as a leading indicator.
There are however, several variables when using the yield curve and the spread to predict future economic activity. Assigning different values to those might lead to different conclusions.
The first step is using short-term and long-term interest rates to compute the spread. Different people use different rates and thus sometimes get different results. Some use the spread between 10y notes and 2y notes. According to Estrella and Trubin that combination happens to give false signals often as those rates are closer to each other than a combination of 10y and 3m rates.
Another caveat is one has to check for consistent inversions. This is the reason for using monthly rates rather than daily ones. On a daily basis the spread might become negative but one could not be sure if the reason is simply a question of short-term supply and demand or represents a deeper change in moods. On a monthly basis a negative spread is cleared of minor extremes. In general the more consecutive months with a negative spread are observed the more sure the recession seems to be.
Having said that let's take a look at some of the monthly yield curve data (available in full on the website of Federal Reserve Bank of New York).
According to that data we don't see the spread to be negative nor do the chances of a recession in the next 12 months seem high. Going back to the beginning of data (1959) we see that the spread has declined significantly but has not approached zero.
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There is an interesting and important point which has to be made when using yield curve as a prediction tool with the above assumptions. The Fed's target rate is close to zero and the 3-m rate is virtually the same or close to it. Thus the chance of the spread going negative seems considerably low given current monetary policy. That, in theory, would mean the chance of recession is negligible. This of course is what the Fed is hoping for but the technical readings in the spread may hide a stronger possibility of recession.
There was a report by Joseph G. Haubrich and Margaret Jacobson of the Federal Reserve Bank of Cleveland near the end of September that also used the yield curve spread to predict GDP growth. It estimated a growth of about 0.8% over the next year. That is in line with the above projections of the yield curve spread that a recession is not very likely to appear in the next 12 months. As with all statistical estimates one should keep in mind however, that they are subject to error and that past performance does not guarantee future results.
Examining the picture we should not forget that not long ago the Fed started its "Operation Twist". As a result of its buying intentions and the buying itself the long-term rates have dropped considerably. The bank is using the maturation of its short-term holdings to buy longer-term, 30-year bonds. Doing this lowers the long-term rates as it creates demand for those bonds. On the other side selling short-term securities does not necessarily decreases the price of those if the demand is enough to cope with the new supply. As problems in Europe and a sluggish economy in the States unfolds, demand for short-term securities has held up. This results in a one sided twist of the yield curve by lowering long-term rates and not increasing by the same magnitude the short-term ones. This decreases the spread which in general is the thing the “yield curve spread” system uses to predict recessions. That sort of artificial flattening of the curve could lead some analysts to conclude another recession is more probable when in fact it is not. Though the yield curve has been a good predictor of future recessions, this is an example of how a single indicator should not be examined alone and outside of its environment.
The macro economic data shows a fairly stable environment in the US while not improving at the speed everyone would like to see. Unemployment hovers around 9% for the last few months and initial jobless claims have come down somewhat compared to previous readings. Retail sales (MoM) showed a considerable increase to 1.1% in September.
As the yield on treasuries comes down from the Fed’s planned operation twist, investors will need to seek other instruments. The available options that come first to mind are corporate bonds and equities. Both of those have the potential to boost US equity markets performance. Investing in corporate bonds, would allow companies to have increased access to fresh capital and grow their business more profitably. That in turn would have a positive effect on the non-structural part of the unemployment and GDP.
In a situation like this, one could profit from selling the overpriced asset, buying the underpriced asset or doing both. If investors believe a recession is not in the cards and the country will continue to advance, a long position in an ETF that tracks broad indices, like SPDR S&P 500 (SPY) could be a suitable choice.
Another option is to take a position in order to gain from the possible rise in corporate bonds prices due to increased demand by investing in funds like the iBoxx Investment Grade Corporate Bond Fund (LQD) or the Long-Term Corporate Bond Index Fund (VCLT). Both have an expense ratio of 0.15% while the former has about 27% of its holdings in bonds with 20-30 years of maturity and the latter is about 80% invested in 20-30 year bonds.
A short of the overpriced asset may lead one to short the of Barclays 20 Year Treasury Bond (TLT) as an option. The ETF has a .15% expense ratio and invests in US Treasury securities with remaining maturities of at least 20 years.
A more focused approach would be to try to escape the risk of investing in the whole market as the overall expectations are still gloomy around the world and find some specific industries that would profit in an environment of low interest rates, low growth and to some extent elevated inflation. Consumer staples could be one opportunity. With the Christmas season approaching, Consumer discretionary could also do well. The Consumer Discretionary Select SPDR (XLY) and the Consumer Staples Select SPDR (XLP) would both be good choices for exposure to the sectors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
