The (brief) interest rate flattening story
Bloomberg News, which tends to both follow and set the agenda for what's happening now and in the somewhat near future, ran a very brief article with a portentous title Wednesday on a topic near and dear to my investor's heart. Here it is in almost its entirety:
The spread between 5- and 30-year Treasury yields, as well as the gap for 2- and 10-year maturities, tumbled Wednesday to the lowest levels since 2007, at 37.2 basis points and 45.7 basis points, respectively. The flattening accelerated after consumer price index data came in largely as expected, perhaps bringing other market-moving events, like President Trump’s threat of a missile attack on Syria, into focus.
An incomplete point in this ultra-brief article is that yield curves routinely flatten in the post-1980 period "relentlessly" when the Federal Reserve inflates short-term interest rates by restricting the supply of money in the financial system. It's doing this again now. As short-term rates rise, savers and lenders are willing to borrow and lend long term at rates closer and closer to short term, "policy" rates. As an example, the Fed tightened severely in 1993-4, but no recession followed; in fact, the boom of the '90s began.
The Fed began tightening in 1999 and finished tightening in Q1-2 of 2000, but the economy kept expanding into about March 2001. The yield curve began getting flat in 2005 after the Fed had been tightening for about one year, but the economy kept expanding for about another 2 1/2 years before the Great Recession began. So the fact that the chart references the Great Recession period is not the complete story by any means.
What is happening with interest rates today, as the Fed tightens policy, is not by itself a recession signal.
But recessions generally are preceded by tight money, often in response to inflation pressures, so it is true that the economy is at higher risk of recession in the next couple of years based on the Fed's tightening and the flattening yield curve. Thus I am wary; but overall, I remain optimistic on the US economy.
There are other more important points to make on the same topic. The main one is that the long-term trend in long-term interest rates is increasingly looking to be flat or down. Here's my take on a key part of the truly big picture.
Points that suggest the trend in long-term rates is flat to down, not up
These methods are related. The simple method is the eyeball method. Here are the rates on the modern 30 year Treasury bond, from Trading Economics:
The same logic that keeps many people in stocks (SPY) or other assets that are "resting" or "consolidating" but that show a long-term uptrend could apply here: the major trend continues to be down, with a lower (lowest) low set in mid-2016. Also, the 30-year appears to be "happy" now around the 3% level, whereas post-Great Recession, it appeared at first to be happy around the 4% level.
Both these numbers as potential equilibrium numbers were unthinkably low before the Great Recession - but as this chart shows, one level after another that looked "too low" has been revealed as a breakable support level for interest rates. It used to be 5% that was "too low" and before that 6%, 7% etc. Yet since 1981, all consolidation patterns in the 10- and 30-year Treasury bonds have broken downward.
Sometimes the break has occurred during recessions, but sometimes not.
It could be a very big deal if this were now like the 1950s and the consolidation patterns began to break upward. I'm unconvinced.
A related, but more complex way of thinking of the yield curve involves measuring the difference in yields between the 10 and 30-year Treasury bonds. As many readers know, these bonds are unique because they are essentially free of default risk, and the bonds are not callable before maturity. My little proprietary innovation is to look at the implied average yield between years 10 and 30, i.e. the last 20 years of a 30-year bond. This tells me what traders are thinking the future holds in a time period that the Fed is not affecting now, other than perhaps 2012 when the Fed was buying long-term bonds.
For example, before the 2001 recession, the yield curve was flat at around a 6.5% for all maturities. Rates dropped before and during the 2001 recession, and then rose into 2006-7. At peak in 2007, the yield curve was again flat at 5.25% (over a point lower than in 2000). The Great Recession led to a collapse in rates, which initially bottomed in December 2008 at about 2.1% for the 10-year and 2.5% for the 30-year. At that time, the math for my metric of average yield for the "last" 20 years of the 30-year bond is as follows:
- interest earned through year 10 = 10 X 2.1% = $21 for every $100 invested
- interest earned through year 30 = 30 X 2.5% = $75 for every $100 invested.
- interest earned in years 11-30 = $75 - $21 = $54
- average interest rate from years 11 through 30 = $54/20 = 2.7%.
This appeared to be a gross anomaly, and by 2010-11, the 10-year was back to about 4% and the 30-year close to 5%. This created an implied average yield for years 11-30 of about 5.5%. Almost all investors thought the Old Normal in rates was back.
But the "anomaly" kept returning, again in 2011 even before Operation Twist artificially lowered long-term rates, and then again in 2016. By then, with the 10-year breaking below 1.4% and the 30-year breaking below 2.2%, the implied average interest rate from years 11-30 was below 2.6%, or a new all-time low.
Now, that number is dropping again. The 10-year is around 2.78% and the 30-year is at 3.00%. The implied yield from years 11-30 is thus only 3.1%. It's not, of course, an all-time low, but it's very low.
Not only are the people and businesses who buy and sell bonds unconcerned about inflation right now, they are also not acting concerned about inflation for the long term. And one of the key rules I follow in investing is that bond traders are very smart. One reason they are smart is that they have actual transactions of real money to watch. Importantly, these transactions are between adversarial parties: the borrower wants to borrow low, and the lender wants to lend dear. Whereas, too much of what goes on in stocks involves front-running buybacks by companies that are not sensitive to the valuation of the stock they buy.
(Note to bond experts: the above is first-order analysis, not thorough and not comprehensive analysis, for brevity's sake. But I think the basic points are valid.)
Next, we need to ask if anything corroborates a sunnier view of interest rates, if "sunny" means low and therefore able to accommodate high equity valuations.
I see two, one market-based and one technical.
Market-based reasons for low or dropping interest rates
The key variable remains oil and gas. Crude oil prices are high related to economic activity and geopolitics. But the futures curve for West Texas Intermediate crude drops sharply. While front end crude is $66.80 per barrel around 4.30 PM Wednesday, the December 2020 contract is only $54.62. The December 2023 contract was above $60 (by memory) in late 2014 and early 2015 when current month crude was dropping toward, then below $50. Now it is only $50.79.
This looks to me like deflation in energy prices is coming. Other commodities are struggling, as well. Even gold is unable to break through its July 2016 high despite all the growth, inflation expectations and geopolitical (and US political) fears. This observation is in my view buttressed by Wednesday's report from Bloomberg that Oil Options Traders Are Most Bullish Since Crude Was Over $100.
The call/put skew metric referenced in a chart in the article shows it at a peak that is almost equal to the peak seen in June 2014 - when oil prices were about to collapse. One never knows with these matters, but this appears more bond-bullish than oil price-bullish to me.
A different Treasury bond-supportive points that is relevant involves the growing number of bond experts who are seeing cracks in the junk bond market. This has been a good predictor of a peak in Treasury bond rates many times before.
Moving on, some technicals have suddenly also turned supportive of flat to lower rates.
Futures traders send a 'buy' signal on bonds
The FINVIZ chart on the 10-year bond shows the speculators now bearish, expecting higher rates (red and blue lines). The green line shows the commercial hedgers (e.g. dealers), who are now net long the bond. In the past, this has been a good or great time to own the 10-year bond or the long (30-year) bond. Here's the chart:
The chart on the 30-year bond is also constructive.
However, just one point is that these positioning trends may end up "working" once more (no guarantees, of course), but they are not great week-to-week timing metrics. Seasonality on bonds turns positive (higher prices = lower rates) in about 4 weeks. Maybe that's what is being signaled here, especially with Syria so much in the news right now depressing interest rates somewhat.
How can one be bullish on bonds when the Federal deficit is large and rising?
Because the Fed is not monetizing it (not right now).
All that is mainly happening with the flow of funds with the Trump-era deficits is that the government is taxing less but borrowing more. But even in theory, that does not tell us what the price of that borrowing will be.
Empirically, there is no correlation between deficits and interest rates, either in the US or in other countries.
Implications for equities
What I am proposing for bonds is, in my humble opinion, ultimately positive for shares of stronger companies. I am analogizing this period of Federal Reserve tightening to such periods as 1994, 1999-20, and 2004-5. I am also analogizing it to the sudden withdrawal of Fed ease in mid-2011, as QE 2 ended, and the gradual withdrawal of Fed ease through most of 2014, in the Taper of QE 3.
Each of these periods was accompanied by resets of interest rates lower, after inflation scares that followed periods of easy money. Many people got bearish on stocks from 1995 on, looking for traditional valuations; but for one reason or another, it was not to be. I am therefore keeping an open mind here. Things can break many ways, but in the next section, I'll summarize my central tendency and then, for anyone interested, my updated investing strategy.
Conclusions - sticking with the major trend is not easy, or even clear
Since most of us are stock market people to at least some extent, it's easy to analogize the bond market's actions to equities where appropriate. So, think of a market, or sector, or individual stock that either does not rise when it "should" or does not drop more when it "should." That is often a sign that the news is about to change and the stock, sector or market "knew something." That's how I am beginning to look at the long bond. The hubbub about inflation breaking out is deafening.
Yet, as of Wednesday evening, gold (GLD) cannot break out. Silver (SLV) is becalmed; so are platinum (PPLT) and palladium (PALL). Copper (JJC) is going nowhere lately. Crude oil is stuck in the $60s even though $80 appeared to be the permanent low 4 years ago. Worse, the "out" years show crude prices virtually collapsing. Cyclical stocks are acting badly, and the US dollar has stopped dropping. All these suggest - but do not prove - that the rampant bearishness on bonds may be misplaced. If so, what will happen when the bears find they have gotten things wrong? A bit of a buying panic, perhaps?
So, what is the major trend here? Is it normalization of monetary policy, forcing normalization of interest rates and normalization of P/E's and other stock valuation metrics? Or, is it just one more Fed tightening cycle leading to a flat or flattened yield curve that will be followed by yet another drop in interest rates? If so, will that lead the US long bond to join the UK and other countries in seeing a 2% 30 year government bond? (Actually, the UK has a 1.76% 30 year bond rate and Germany has a 1.15% 30 year bond rate.)
The types of stocks and other assets to own will differ, I believe, if interest rates and inflation/growth are breaking to the upside soon, versus to the downside. And, of course, these are just two of many interest rate scenarios that could occur. All that uncertainty argues for elevated cash reserves as I see it.
Thus, while the brief Bloomberg article about 'relentless' yield curve flattening is relevant, what it does not explore is much more important than the little bit of data it shows.
I've been around the markets for over half a century, since I was a teenager charting stocks as an after-school job. I've been an investor for nearly 40 years. While change is constant, my observation in real time has been that usually, paradigm changes are not necessary.
But since the crisis of the Great Recession, then the non-rules-based "money printing" regimen of QE, and now the non-rules-based reversal of QE (also called quantitative tightening), investors have been flying semi-blinded. The absence of an obvious big picture trend right now also suggests an important role for cash, which in money market funds is already yielding about as much as the dividend yield on the SPY.
Here is a final key question and concern: If QE 3 did not stimulate inflation, will its reversal (and potentially removal of part of the money created in QE 2 in 2011) plus interest rate increases stimulate deflation? After all, money makes the economic mare run. With so many questions, and so many analogies of interest rate flattenings with corrections or bear markets in stocks, extra cash on hand continues to make sense to yours truly. As far as rates go, I do think they bear watching, and I continue to maintain a fair amount of exposure to the bond market (TLT) as well as utility stocks (XLU).
Thanks for reading and sharing any comments you wish to contribute.
I will be traveling and will try to read any comments by Thursday night.
Submitted Wednesday evening; 30-year T-bond at 3.00%, 10-year T-note at 2.78%, S&P 500 futures at 2646.
Disclosure: I am/we are long TLT,XLU. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.