Financial markets are complicated, dynamic and contain too many variables for any simple equations or theories to truly capture. That said, one can still derive very useful observations from trends that do manage to reflect a few critical elements simultaneously.
One such trend can be found by watching movements in the treasury markets. Even though the stability of United States Treasuries (NYSEARCA:UST) has been questioned by some pundits over the past several years, investors still see them as a security blanket when the expectation is for market turmoil and they are inextricably linked to the Federal Reserve's Open Market Operations.
When separate Treasury yields move in opposite directions, like they are now, it tells us something fundamental about how future markets are shaping up. Particularly, a spread between long-term and short-term issues usually reflects market participants' expectations of future monetary policy, credit demand and stable investment prospects.
History of 10-2 Spread
The difference in yield between the 10-year Treasury yield (USGG10YR:IND) and the 2-year Treasury yield (USGG2YR:IND) -- sometimes called the "10-2 Spread" or "2-10 Spread" -- has a very compelling story to tell regarding market confidence and "flights to quality."
We have data on both Treasuries dating back to 1976. Here are some correlations of note:
- A large or increasing spread has correlated very highly with a multi-year growth in the markets.
- The 10-2 spread has only been negative (2-year yields higher than 10-year yields) in five time periods (1979, 1981, 1989, 2000 and 2007); each period of negativity was followed by a recession.
- The 10-year UST has only consistently yielded 2.0% or more above the 2-year UST in three time periods (1992-94, 2002-04; 2009-11). Following both 1994 and 2004, the 10-2 spread saw precipitous declines that were mirrored with rapid gains in the stock market indices before the bursting of an asset bubble.
Treasury Yield Trends in 2014
By the New Year, 10-year Treasury yields had climbed to above 3.0%; 2-year yields hovered around 0.4%. Thus, we saw a high 10-2 Spread at 2.6%.
Since that time, the 10-year has dropped to 2.42%; the 2-year has seen swings in both directions, currently sitting at 0.41%. The 10-2 spread has seen a continuous decline and is now under 2.0%.
Why the sudden drop? Why do long-run prospects now seem so much less certain than in January?
Troubling Q2 Data Suggests Weak Foundation
Much of the troubling Q1 data was blamed on weather-related phenomena. The media let out a collective sigh of relief when GDP grew in Q2.
I think they are missing the point. There was plenty of troubling information in the Q2 figures overshadowed by 4.0% GDP expansion and 6-straight months of 200,000+ job growth.
For instance, if you take a look at the most recent jobs report, all of the growth occurred among the youngest and the oldest members of the labor force. Those between the ages of 16-24 and those age 55+ both recorded net job growth; amazingly, workers between 25-54 actually lost over 100,000 jobs in July.
Additionally, unemployment rose to 6.2% despite the job gains -- which is importantly only to the extent that it highlights the fact that our labor participation rate remains near all-time lows (62.9%, according to the Bureau of Labor Statistics).
The Employment Cost Index rose again, which calls into question the among of "slack" in the economy and suggests that hiring -- especially full-time hiring -- remains difficult. Housing figures are slowing down despite the fact that mortgage interest rates remain very low.
The little known measure Gross Domestic Income (the sum of income received by all sectors of the economy) continued to fall. Declining GDI has historically preceded weak economic activity.
To sum: jobs are not being added in important key demographics, hiring is increasingly expensive, labor participation is still dramatically low and real incomes are falling. Companies added a lot to their inventories in Q2, but that is a very poor indicator of future activity.
Compound this with extreme uncertainty in European markets and about which actions the Fed will take... some flight into the 10-year Treasury Note is understandable. We are seeing much of this uncertainty being captured in the 10-2 spread, and should continue to see the same in Q3.
It is highly unlikely that we will see a negative 10-2 spread as long as the Fed maintains a near-zero interest rate policy (and with questionable "slack," raising rates is risky). However, a spread that keeps approaching 1.0% could very well be a precursor to market struggles. As yields continue to decline, you may see a spike in other hedges as investors continue to look for safe value.*
*It remains to be seen how the Fed's newest baby, the ON RRP facility, impacts investor flight to safety. That will be something well worth watching. It is possible that corporate bonds see decreased activity.
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