The Flattest Yield Curve

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Includes: BCS, CS, DB, EGF, FTT, GOVT, GS, HSBC, KBE, KBWB, PLW, SAN, SCGLY, SPY, TAPR, XLF
by: Ivan Martchev

The decent employment report that finally showed some wage gains was the catalyst for a stock market sell-off last Friday. The market acted as if future fed fund rate hikes are coming back into the picture - but in my opinion they aren't. At the beginning of the year, fed fund futures and other short-term interest rate markets like euro-dollar futures were pricing in four rate hikes. As January progressed those rate hike probabilities vastly diminished. You can see that in the plunge in 2- and 10-year Treasury note yields so far in 2016.

Two Year United States Treasury Yield Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The 2-year (red) and 10-year (black) Treasury note yields peaked right after the terribly misguided Fed rate hike in December. They closed last Friday at 0.74% and 1.85%. It is worthwhile pointing out that on Friday the 2-year note yield was up (due to some evident wage cost pressure in the employment report) while the 10-year note yield was down (probably due to the global deflationary outlook).

It is also worth noting that the 2/10-spread - the difference between those two benchmark interest rates, otherwise referred to by its technical term, the slope of the yield curve - is the flattest it has been since January 2008 when the Fed was already embarking on a series of panicky rate cuts at the onset of the Great Recession.

Ten Year Treasury Constant Maturity Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It is a fact that inverted yield curve situations have preceded every one of the last five recessions and so have Fed rate-hiking cycles. While we are far from an inverted yield curve, we are definitely seeing a flattening yield curve, which typically signifies a slowing economy. A slowing economy in the U.S. at the time when the global economy is even slower is not an environment for Fed rate hikes, in my opinion. The fact that 2- and 10-year Treasury note yields dropped like rocks in January means that the bond market is signaling to the Fed that they have made a major mistake with the rate hike. It is also a warning to the Fed that they should stop before they do any more damage.

The flattening yield curve can also be seen in the performance of the financial sector, which has been notably under pressure in 2016. The KBW Bank Index would be a good gauge for the sector while a more tradeable ETF equivalent would be the Financial SPDR (NYSEARCA:XLF). Banks hate flattening yield curves, which tend to hurt their profitability. Banks borrow short and lend long, so the steeper the yield curve, the fatter their net interest margins. Another reason why banks don't like flatter yield curves is that they represent slower economic growth, or even recessions, which tend to produce more losses for their business.

(Please note: Ivan Martchev does not currently own a position in XLF. Navellier & Associates, Inc. does not currently own a position in XLF for client portfolios.)

Financials Select Sector Exchange Traded Fund Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Banks notably underperformed the S&P 500 in the fed rate hiking cycle at the turn of the last century in 1998-2000. They also notably began to underperform in the Greenspan-Bernanke rate hiking cycle in 2007, even though the problems in the mortgage markets were so large that no rate cutting by the Fed could have saved them in 2008. The banking sector was notably under pressure in 2011 in the eurozone crisis for fear of contagion and is embarking on another such cycle of underperformance in the great global deflation scare of 2016, this time in large part driven by China.

Banks hate deflation because their net interest margins tend to contract, but also because nonperforming loans (NPLs) tend to climb as deflation - falling prices in the global economy - tends to increase the real value of debts while corporate and governmental revenues are weak and falling. Japanese banks are good examples of what happens when deflation sets in, as they could never really embark on more sustainable profit growth cycles after 1990. Recently, a lot of large global European financials are beginning to remind me of the Japanese banks in the 1990s as some have taken out their 2008 financial crisis lows (according to Barchart.com) - like Deutsche Bank (NYSE:DB), Banco Santander (NYSE:SAN), and Credit Suisse (NYSE:CS) - while others are rapidly approaching those 2008 lows, like HSBC (NYSE:HSBC), Barclays (NYSE:BCS), and Societe Generale (OTCPK:SCGLY).

(Please note: Ivan Martchev does not currently own positions in DB, SAN, CS, HSBC, BCS, or SCGLY. Navellier & Associates, Inc. does not currently own positions in DB, SAN, BCS, or SCGLY; these positions have been held in past client portfolios. Navellier & Associates, Inc. does currently own positions in CS and HSBC for some client portfolios.)

In that regard, the U.S. banking sector is faring much better, given what is going on with banks globally; but my point is that U.S. monetary policy affects the whole world, whether the Fed likes it or not (I think they do), so the last thing the world needs in the present environment is more Fed rate hikes.

The Ultimate Financial "Canary" Stock

Every time we get into some financial market turbulence, I tend to keep a close eye on a particular stock. Sure, the financial sector is important; but there is a particular company that has leverage to the economy and financial markets' performance globally that makes for a better "tell" about where things stand, and where they are headed.

That company is Goldman Sachs (NYSE:GS).

Apart from the conspiracy theories that have given them the nickname Government Sachs - after all, senior Goldman Sachs executives served as both Bill Clinton's and George W. Bush's Treasury Secretaries - this venerable Wall Street firm is famous for outmaneuvering its rivals over the past 20 years. Just look at this relative chart of Morgan Stanley (NYSE:MS) and Goldman Sachs and you may reach the conclusion that its closest rival is habitually a day late and a dollar short. Meanwhile, the former GS rivals are either bankrupt (Lehman) or have been bought out at cents on the dollar (Merrill).

Goldman Sachs Group Morgan Stanley Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

So what is the Goldman canary saying now?

Goldman Sachs Incorporated NYSE Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Goldman almost (but not quite) made an all-time high in 2015 and appears to have completed a head and shoulders top with the "head" at $217 and the "neckline" at $170. That technical pattern implies a move down to $120 or so. But, as readers of this column know, I cannot place my faith blindly in squiggly lines alone. I think global deflation is bad for Goldman Sachs as it will make their overall business much more problematic, be it investment banking, asset management, or capital markets/trading.

Many investment firms, including Goldman, used to blame QE for the lack of volatility in financial markets for years, which caused them to lay off plenty of traders in their fixed income trading units. They are finding the results of the Chinese curse "may you find what you are looking for" as the Fed is trying to normalize monetary policy - at a highly inopportune time, in my opinion - while volatility in fixed income, bonds, and commodities is exploding.

So the next time you wonder if the stock market is on firmer footing, pull up a quote for GS. Given this is still the best-run Wall Street firm, its stock says as much about Wall Street as about the company itself.

(Please note: Ivan Martchev does not currently own positions in GS or MS. Navellier & Associates, Inc. does not currently own a position in GS for client portfolios; this position has been held in past client portfolios. Navellier & Associates, Inc. does currently own a position in MS for some client portfolios.)

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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