As we pass tax day in 2018, there is slight uptick in optimism over the past week in the stock market (SPY) (DIA) (QQQ). The political spin is that Main Street is spending because of the tax cuts and economic activity is increasing. I personally think it is the tax cuts that are driving stocks. But being more of a skeptic, I believe that the corporate buy-back window is being lifted as earnings are reported, and the anticipation for a continued recycle of corporate tax cut dollars into buy-backs is being front-run by stock traders. The real truth may be somewhere between these extremes, but I don't see much evidence of US expansion-driven growth as a narrative in support of future stock growth.
This leads me to the credit markets, which I trust will be the harbinger of what is to come for the stock market, as it is in pretty much every historical case. And today's credit market is swamped with new Treasury supply being issued because of the Tax Reform Bill passed in December of 2017. And the new supply since the beginning of 2018 is driving Treasury interest rates higher, which indirectly is beginning to crowd out stock market investment, hence the 10% correction in early February. It was early February when the Treasury hit the market with over $200B in new public money in a 2-week span.
Since early February, the financial market has absorbed $650B in new issuance as of 4/11/2018 and is actually getting a slight reprieve over the last couple of days as debt has been temporarily reduced by ($74B). The incoming tax collections around tax day probably mean the Treasury will likely be less of an influence in the market for a short while, and the corporate buy-back machine in the tech sector can come back in force. Over the short term, the market is open for upside volatility, and I suspect it will try to make a run at the January all-time highs again in the remainder of the second quarter as the yield curve continues to tighten and rates head higher on both the long and short end of the yield curve.
Potential short-term trading opportunities aside, the full year (next several years) stock investment dynamics remain negative, in my review. Rates are headed higher unless there is a sudden cataclysmic downturn, and the Treasury is going to be the driving force as the current economic plan is executed. And stocks are currently priced to perfection as if long-term rates are remaining below 2.6% on the 10 year, and as if worldwide Central Banks will remain accommodative. The pull-back in the 10 Year rate at the end of the 1st quarter was a brief bear market rally in my review. Although the continued low long-term rate scenario is possible, particularly if we remain in a deflating economic world, I say it is now not probable, given the change in fiscal policy being put into effect in the US. Here is the recipe for triggering a second deflationary wave - tank the stock market through Fed over-tightening with ancillary help from the Bank of Japan, create a massive safe haven bid for Treasuries by panicked stock investors, and then borrow large amounts of money from China and Japan to finance a large consumption focused U.S. fiscal spending spree.
If this sounds like the year 2008, it is because it is what happened from a funds flow standpoint. You can pick your own narrative for the cause and effect leading up to the crisis. I tend to keep an eye on the financial plumbing, not the news spin cycle.
But what if the flow of funds during the next financial system Central Bank contraction works differently in the next stock down cycle, and is inflation biased rather than deflation biased? In my review of current trends, I am beginning to conclude that, in all likelihood, it will not be driven by deflation. And the number one reason it will not be is that the probability of allowing China to be the go to bail-out master, or the International market in general in the next hard market fall is Slim and None presently, and Slim looks like he left town. If the "dirty float" channel is shutdown for China to devalue its currency against the US Dollar, as it did in 2008-2010 during the crisis, then consumer price deflation in the next crisis is far less likely to materialize. Add a trade war where tariffs are being placed on Chinese imports in order to force a balanced trade deficit over time as an economic policy, and the return of US inflation becomes a realistic possibility. (For more detail, see article What Will Make America Inflate Again?)
However, asset value deflation remains a big risk that is very likely, if not unavoidable over the next year several years in the markets. The only question in my mind is how big will the actual drop be? Total financial market debt levels in the US stand at $69T, a historic high.
The debt level is not an issue if it can be serviced. However, as the GDP growth line illustrates, the US economic growth trajectory is not keeping pace with the added debt load. The ratio now stands at 3.5x N-GDP as the pace of economic growth has not yet turned aggressively upward in either real of nominal terms under Trump, regardless of the hype.
Although the credit spree in the US, which started back in the mid-1990s, accelerated during the Bush administration and was re-kindled by Obama post the 2008 financial crisis is not sparking major economic growth or inflation, it certainly has juiced the stock markets through time.
As you can see in the chart, whereas the US GDP may be trailing when it comes to the piling on of more and more debt into the economy, the stock market on a relative basis has been the beneficiary. And I have added an additional data point into the chart so that readers can align where the credit market is today versus the 2008 financial crisis. The Treasury yield curve in April 2005 was around 50 basis points on the spread between 10s and 2s, the same level it stands at today. However, the stock market is priced at a level which is over 1.5x times higher on a relative basis. And the reason that stocks are so much more expensive on a relative basis is directly linked to the massive expansion of Central Bank balance sheets over the last 10 years. The correlation of the US stock market to worldwide central bank balance sheet expansion is extremely high, and unprecedented.
The coordinated asset buying programs is credited in the current market "narrative" with creating a synchronized global growth story. I can't help but point out that what goes up together will come down together for the same reason, and that, historically, stock markets have moved up and down together, only for different reasons. In the 9 year span between 1999 and 2008, there was little correlation between central bank policies and the US stocks. However, underlying the figures, there was a definite impact of the BOJ's decision to contract its balance sheet from 2006-08 leading up to the financial crisis. Additionally, tighter Fed policy during the same time period was highly correlated with the eventual outcome. (For detailed review, see Overfed Stock Market Getting Ready To Go On A Crash Diet)
Upcoming Central Bank reversals of asset buying programs in the ECB and BOJ will be a definite contracting (deflating) pressure in the international financial markets. The Federal Reserve is already in the process of contracting its balance sheet on a path which is estimated in the following graph:
Trump's Economic Plan Designed to Counter Asset Price Deflating Force - Will it Work?
So, the risk is high that the massive level of debt in the financial system that was created by the recent Central Bank asset buying sprees and accommodative policies will lead to a major debt default chain reaction, which is a major cause of economic deflation conditions; however, the current financial system is still primed with high levels of excess liquidity, (see US Excess Reserve data here) which unless it were to be suddenly removed, credit default risk will only slowly return to the system. The credit system will likely just keep continuing to roll over the existing bad credits rather than foreclose. The bigger risk now in my assessment is that Central Banks choose (are politically forced) to err on the side of leaving excess liquidity in the system this time around, given the calamity created in 2008.
But there must be a strong force in the opposite direction to counter-act the coming Central Bank balance sheet contraction in order to avoid another stock market deflation led economic crash like 2008. Enter the Trump economic plan.
By design, the Trump economic plan has given corporations cash flow through tax reform to defend their share value or pay down debt to offset the asset deflating impact of upcoming contracting Central Bank balance sheets. The Treasury, in effect, is underwriting the financing for this counteracting force by keeping liquidity in the system where a major issue is going to materialize. In addition, Trump may naively expect real growth to suddenly be sparked in the US from his new policies. Rome was not built in a day, and the trade deficit problem he is addressing took 30-40 years to create. I for one am not expecting immediate miracles. And the biggest obstacle to US growth will be CFOs who will not suddenly change course and invest in US production against the prospects that in less than 4 years that a new political regime will just re-open the "dirty-float" trade mechanism that underlies poor US growth and has led to price deflation, immediately destroying the value of any investment made today. More likely, the near-term impact will be just higher consumer goods prices, and a weaker dollar which cause the price of oil to spike, my number one indicator of future deflation coming for stocks. (See Chapter 10, Theory of Financial Relativity - Oil's Shocking Relativity)
Currently to the ire of President Trump, and in the face of continued high US production, the front end of the WTI curve is approaching $70. This market still has room to run higher now that the Saudi's and other OPEC nations have tapped the financial debt markets (like the rest of the world) so that they pay for their economic consumption without selling more oil. Looks like the synchronized Central Bank debt mirage machine has finally been undermined by a true economic force. The more underpriced money is borrowed for the purpose of leaving oil in the ground (or in tankers), the higher the inflation rate will be around the world.
The day of reckoning for inflated stock market prices is approaching. The only question in my mind is how the crash will transpire, and how the financial landscape will look in the aftermath - inflationary as in the 1970s or deflationary as in 2008.
Inverted Yield Curve Signal Widely Watched Indicator of Stock Market Trouble Ahead
A key signal many investors will be watching to understand when the day of reckoning is near for stocks is the inversion of Treasury yield curve, with particular attention usually focused on the spread between the 10 Year (IEI) and the 2 Year Treasury (SHY). And since the beginning of 2018, the spread has fluctuated around 50 basis points, with an expansion to 78 basis points in mid-February as the stock market was in correction turmoil, but more recently, a contraction to 41 basis points.
It is the contraction, and the prospect for a future inversion that currently has the attention of many investment strategist and analysts. The problem I have with much of the current wisdom being rolled out for investor consumption is that it generally suffers from what happened most recently (deflation driven curve tightening), and it does not account for the fact that the Treasury is limiting new supply of the 10 year relative to shorter maturities, international demand for Treasuries (see TIC data here) is now falling in recent months rather than rising as it was in 2007 and 2008, and the Fed is still in capital control mode with plenty of excess reserves in the banking system tank (see here). In other words, this scenario is different then 2008. And it is even significantly different from the year 2000.
So, with this in mind, I offer the following data for those who follow my articles which will give some perspective on how to interpret a yield curve inversion relative to stocks in a rising rate inflation driven market (with low international fund flow influence) versus a falling rate deflation driven market (with high international fund flow influence).
In the graph below, which spans the last 66 years of market history, I have plotted the 10/2 Treasury interest rate spread over time and added the points in time the market corrected by 10% or more from a peak to trough basis on a month over month basis. Since the mid-1960s, the major stock market "crashes" of 20% or more in the diagram began in March 1966, Nov. 1968, Dec. 1974, Nov. 1980, Aug. 1987, Aug. 2000, and Oct. 2007. It remains to be seen if Jan. 2018 becomes another similar stock "crash" peak in history, or just a correction along the way to higher stock prices. Currently, I place the probability as high that it will be a "crash" peak.
In the graph, you will notice that there is one glaring characteristic difference in the yield curve inversion in a true inflation led rising rate market versus a deflating lower interest rate trend market. And that difference is that the yield curve inversion happens after stocks have peaked, and it persists for a long period of time until the stock market finally cries "uncle".
A closer inspection of the inversion dynamics over a tighter time window will show the difference more vividly.
Last Two Major Stock Market Crashes Occurred after Yield Curve Inversion
In the case of the year 2000, Treasury interest rates were relatively high, borrowing needs were low, thanks to a temporary fiscal budget surplus, and the stock market breakdown from the dot.com peak was gradual. The bottom in the market decline was not set until Sept. 2002 and confirmed in Feb. 2003. At that point, the 10/2 spread had expanded back above 2% after reaching a negative low point around the stock peak in the summer of 2000.
The 2008 market crash was much more abrupt, but was preceded by a very long time span in which the 10/2 spread was either close to 0% or negative. During the financial crisis in 2008, the Federal Reserve unloaded Treasuries from its own balance sheet tightening financial conditions even further, but interest rates fell anyway as the large volume of international "safe-haven" buying of Treasuries primarily from China drove Treasuries lower. The interest rate signal that was most visible during the crisis was the rapid fall of the 2 Year Treasury rate.
The 2008 crisis is a signature lower rate, asset deflation driven yield curve inversion where foreign capital flows into Treasuries seeking a safe haven happened simultaneous to a sharp sell-off in equities. The data show that China was a major buying player in the Treasury market as the mayhem transpired.
The Stock Market Crashes in the 1960s and 70s Started Before Yield Curve Inversion
If you dial back the financial market clock to the 1960s and 70s, you will see that the yield curve inversion relative to stock market peaks happened on a different timing cycle.
As you can readily see in the graph, 3 major stock market corrections began in the 1960s and early 1970s ahead of a significant inversion of the Treasury yield curve. In fact, in the late 1960s, the yield curve was persistently in a range from 0 to 20 basis points for a considerable time (2 years plus) leading up to the stock market crash. Once the market began to "crash", it bottomed at the same time that the yield curve was at its most negative point. In all three cases shown in the graph, the market bottom occurred as the yield curve was reversing from its most negative point. This pattern in a rising rate market is vastly different from the yield curve inversion scenarios experienced post 1981 when rates began a 40-year decline and international dollar investment flows into US Treasuries substantially increased.
How Does the 1968 Scenario Stack Up to 2018?
When reviewing historical yield curve data, it is important to understand that the situation faced by the Treasury at any point in time is unique to that period of time, and it is the situation that creates the behavior of the yield curve. The biggest difference I have found between the 1960s and 70s versus today is the foreign trade deficit. Up until the late 1960s, and really not starting in earnest until the 1980s, the US did not have a trade deficit; it ran low, but persistent trade surpluses dating all the way back into the 1800s. In addition, international trade was backed by gold which made every dollar in US trade convertible into gold at $35 per ounce under the Bretton Woods system instituted post WWII. Since the US did not have a trade deficit and most trade dollars were converted back into gold, any deflation driven impact of wage differentials between the US and the rest of the world had to be absorbed within the US economy. The primary driver for inflation became the "tax and spend" government fiscal policy which pushed higher and higher quantities of money into the US economy which was supply constrained relative to the government stimulated demand.
Although government borrowing during the 1960s was an order of magnitude lower than today, it was the relative rate of change in debt needs that drove the interest rate market, as the federal government entered the market and began to crowd out other available investment options. In 1968, there was minimal supply of re-cycled foreign flow of USD, which is the opposite of the market scenario experienced for the last 30 to 40 years. Thus, the large relative increase in Treasury borrowing need in 1968 of $1B per month for 18 months, which was about 5% of the outstanding public debt at the time on an annual basis, caused a substantial move in Treasury rates on both the long and short end of the curve, but the spread between 2s and 10s remained persistently low, and did sink to a high minus territory until well after stocks began to decline from peak levels.
Now, let's fast forward to 2018. The Treasury increased public debt outstanding at an annual rate of $500B in FYE2017 slightly lower but pretty much in line with the past 4 years. However, in FYE2018, the rate is going to be closer to $1.2T on an outstanding balance of $15T which puts the borrowing need at 8% of the current outstanding public debt balance on an annual basis. Voila, you have an accelerating government need for financing that is even worse than the 1968 time period. In addition, you have an international flow of funds to fund the Treasury that is currently moving in the negative direction as the Trump economic plan works to tackle the "dirty float" issue that has persistently led to higher and higher trade deficits. The one aspect of the scenario for rampant inflation that is missing is very large (10% plus) increases in year over year fiscal spending, which was present from 1966 through 1968.
Currently, the Federal government is increasing the fiscal spending rate in the 4% range under the Trump plan. However, since tax cuts are a form of spending if they are just a pass-through to consumer consumption, the net effect may actually be economically equivalent. The same logic stands if the corporate tax cut is not spent on investment, but rather is just consumed by corporate buy-backs and indirectly spent on consumption by the selling party as may increasingly be the case as more baby boomers enter retirement.
Interpreting the Current Yield Curve Flattening
The burning investment issue that needs to be considered today is just how to interpret the tightening yield curve which is materializing in 2018 and what is the implication for the stock market going forward?
The current yield curve in many respects resembles the structure that was evident in April of 2005 time period prior to reaching an inversion point in February of 2006. But again, I would strongly advise not to read the current curve as being indicative of a re-run of the 2008 financial collapse, which happened 3 years later after the stock market went up from 1,158 to over 1,500 providing gains of over 30%, expanding on a relative basis to almost 1X N-GDP. Today, stocks are already priced at 1.25X N-GDP, and the current volatility already signals trouble ahead for investors at the current valuation level. So, in this regard, the possibility that the stock market will continue to fall from this point forward, similar to the 1968 scenario is very high. And, in fact, just as in the 1968 scenario, in all likelihood, interest rates will need to continue to rise in order to fund the Treasury as the safe-haven international bid from China for Treasuries will not materialize as it did in 2008.
Under the present probable order of events, the next true stock market bottom will likely be reached when the yield curve reaches its greatest point of negative inversion, not when it has bounced back to plus 2% as it did in a declining rate deflationary market scenario. This will be the point in time the Fed is forced to intervene by backing off its quantitative tightening path and monetize the Treasury debt by lowering rates on the front end of the curve by buying the debt off the market. In addition, I expect the fiscal purse strings to be loosened even further in the next major stock market downturn because the timing will almost assuredly line up with a true economic recession. By doing to, the long end of the curve will most likely rise rather than fall due to a shift in future inflation expectations. In other words, the aftermath of the next financial downturn in this likely unfolding scenario will be inflation driven, not deflation - the opposite of 2008 and the year 2000. In fact, it would be the opposite of every stock market crash dating back to 1980 when interest rates peaked.
If this scenario transpires as I strongly suspect that it will, you will truly know that the 40 year trend toward lower and lower interest rates is over. Either way, deflation or inflation, the stock market is very likely going to be a relative loser over the next several years.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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: My investment portfolio may own stocks and bonds contained in the ETFs referenced in the article.