Treasury Yields Point To A Looming Bear Market In 2018

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Includes: GDX, GLD, QQQ, SPY, TLT
by: Matthew Yates

Summary

Previous major bear markets have been preceded by a negative difference between 10-year and 2-year U.S. treasury rates.

The long-term trend in the yield curve shows that the next bear market could be right around the corner and start with a positive yield curve.

The chart of the 10-year treasury rates shows that the 30+ year bull market in bonds might be ending.

The popping of the bond bubble will have tremendous negative impact across the economy.

A flattening yield curve on U.S. Treasuries is a well known indicator of economic stagnation. As the rate of short-term debt approaches the rate of longer-term debt, it has historically indicated a slowing economy. An inverted yield curve, in which short-term rates are higher then long-term rates, has indicated that a recession is near. Yield curves have been inverted preceding the major bear markets for stocks in 1980-82, 2000-02, and 2007-09. At her recent Dec. 13, 2017 press conference, Federal Reserve chair Janet Yellen indicated that the flatting yield curve may not be a concern, stating:

Now there is a strong correlation historically between yield curve inversions and recessions, but let me emphasize that correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.

Last week, Mohamed A. El-Erian, the former CEO of PIMCO, wrote an opinion piece in Bloomberg titled "Now Is Not The Time to Worry About the Yield Curve." In the article, El-Erian lists a number of reasons why he thinks the stock market will respond differently to the flattening yield curve than it has in the past. He also lists some reasons why he thinks the trends seen in the yield curve will reverse in coming months.

Upon looking at some of the long-term trends in treasury yields, I strongly disagree with the experts. Not only is the flattening yield curve a cause for concern, the next bear market in stocks may be right around the corner. If trends continue, we may never see an inverted yield curve because the next major bear market may even begin with a positive yield curve.

In this article, I have defined the yield curve as the difference between the 10-year and 2-year U. S. Treasury rates. The historical 2-year Treasury rate is plotted here from 1988 to 2017:

30 year plot of $UST2Y (Chart courtesy of StockCharts.com)

The above chart shows that the 2-year Treasury rate bottomed in 2011, and the rate has been increasing exponentially since 2013. The above plot is on a semi-log scale, so that the linear channel indicated by the blue lines indicates exponential change.

Next, consider the historical 10-year Treasury rate over the same time period of 1988 to 2017:

30 year plot of $UST10Y (Chart courtesy of StockCharts.com)

The above chart is illustrative of the unprecedented bull market in bonds, with rates decreasing over the past 30 years. A clear linear downward trend is illustrated with a blue line. Over the past 30 years, the rates broke above this trendline only twice. The first time was in 2007 right before the financial crisis. The second time was last week. The data in the above plot are plotted on a linear scale, so the blue line indicates that 10-year Treasury rates have been decreasing linearly since 1989.

Since 2-year Treasury rates have been increasing exponentially over the past four years while 10-year rates have continued to decrease linearly, the spread between them has narrowed sharply in recent years. Previous major multi-year bear markets have historically followed an inversion of the yield curve. This is illustrated by plotting the yield curve (defined as the 10-year Treasury rate minus 2-year Treasury rate) from 1978 to 2017:

40 years of yield curve (Chart courtesy of StockCharts.com)

The above chart is annotated with a blue trendline and gray ovals highlighting where the yield curve has been near or below this trendline. Prior to the 1980-82 bear market, the yield curve was deeply inverted with values below -2%. At the time, the Federal Reserve was fighting inflation by increasing interest rates sharply. The 10-year Treasury rate was near 14% preceding the bear market that began in 1980. Prior to the 2000-02 bear market, the yield curve also inverted, but the lowest values of the yield curve were only near -0.5% before the bear market began. The 10-year Treasury rate was approximately 6% back in 2000. Prior to the 2007-09 bear market, the yield curve inverted again. The lowest values of the yield curve in 2006-07 were only approximately -0.2%, while the 10-year Treasury rate was only around 4.5%.

Chair Yellen is correct that correlation does not equal causation. However, long-term trends on financial charts do tell us something. As the Treasury rates have marched lower and lower over the decades, the minimum values observed in the yield curve have trended higher. There is no guarantee that this worrisome trend will continue. If it does, though, we are on the cusp of the next multi-year bear market.

More disturbing to me is the fact that the charts may be showing the final end of the bull market in bonds. As noted above, the 10-year Treasury rate has been decreasing linearly for over three decades. The only time 10-year Treasury rates have broken above this downward trendline was immediately preceding the financial crisis in 2007 and again last week. Here is a another look at the 10-year Treasury rate, this time plotted from 2008-17:

10 year plot of $UST10Y (Chart courtesy of StockCharts.com)

The downward sloping blue line is the same multi-decade trendline taken from the longer-term plot of 10-year Treasury rates. The gray oval shows that this trendline was just broken with rates rising above it last week. The breaking of such a long-term trend may indicate a major market shift is under way. The horizontal blue line indicates a possible double bottom pattern. The minimums in 10-year Treasury rates seen in 2012 and 2016 may prove to be the ultimate lows for this extended bull market in bonds. We may never see rates that low again for a long time.

If the bull market in bonds is truly ending, there will be a significant negative shift in the U.S. economy. Uncontrolled rising rates will put U.S. government solvency at risk. The spillover effects of rising rates could be devastating to the economy. The $1 trillion student loan bubble may burst. The housing market is in danger again. The consumer credit bubble driving, among other things, the boom in auto loans may also come to an end. Corporate stock buybacks that have been helping to lift the market may also be heavily curtailed. Given the historical trends and possible negative outcomes, I have to disagree vehemently with Chair Yellen and Mr. El-Erian. Now is precisely the time to be worried about the yield curve.

What should an investor do to protect themselves? If you believe that a new extended bear market is right around the corner, 2018 may be a good year to sell some winners, both in bonds and stocks. The U.S. Treasury ETFs, such as TLT, have seen an impressive run-up in price over the past decade, as have the broad stock market investment vehicles such as SPY and QQQ. Those fortunate enough to have been invested over the past decade may want to lock in some of the remarkable returns. There is a chance that we will see pullbacks in prices of both stocks and bonds in the near future.

The real question for investors to answer is not what to sell, but what to buy. As Sun Tzu said:

In the midst of chaos, there is also opportunity.

What sectors will outperform in the next bear market? We can once again attempt to look at history for guidance. In the 2000-02 bear market, gold outperformed the S&P 500 significantly. Here is a chart of the price of gold divided by the S&P 500 index over the period of the 2000-02 bear market:

(Chart courtesy of StockCharts.com)

The chart above is gold priced in terms of the stock market and shows consistent gains. From 2000-02, the S&P 500 declined by nearly 50%, while the price of gold increased by about 15%.

During the 2007-09 bear market, gold also greatly outperformed the S&P 500. Here is a chart of the price of gold divided by the S&P 500 index over the period of the 2007-09 bear market:

(Chart courtesy of StockCharts.com)

Again, gold priced in terms of stocks showed consistent gains over the entire bear market period. From 2007-09, the S&P 500 declined by 56%, while the price of gold increased by about 26%.

Will history repeat itself? It should be noted that the last two multi-year bear markets took place against a backdrop of a bull market in bonds. In fact, had you chosen to invest in Treasury bonds through TLT during the 2007-09 bear market, you would have had better returns than you would have had by holding gold. Here is a plot of the price of TLT divided by the S&P 500 index over the period of the 2007-09 bear market:

(Chart courtesy of StockCharts.com)

The TLT exchange traded fund showed consistent gains in terms of stock prices over the bear market period. From 2007-2009, the price of TLT increased 38% while the S&P 500 declined by 56%.

I fear that bonds will not be a good investment in the next bear market. What will be a good investment is the trillion dollar question. The answer depends not so much on what you believe the future nominal interest rates will be, but rather the future real interest rates. The real interest rate is the rate of return after discounting the rate of monetary inflation. Will the Federal Reserve continue its recent pattern of raising rates even if the stock market starts declining? Will quantitative easing be resumed in response to another major stock market sell-off? If inflation picks up because of quantitative easing, will the Federal Reserve raise rates sharply to stay ahead of inflation even if the stock market collapses? The Federal Reserve may get backed into a corner in a lose-lose situation. The path the Federal Reserve chooses to take in response to the next bear market will have significant impact on investors. It might be wise for investors to consider hard assets, including gold, as a defensive investment strategy against this looming market uncertainty.

Disclosure: I am/we are long AEM, NEM, TGLDX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.