The Yield Curve Is Persistently Signaling That Danger Lies Ahead

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Includes: AGG, BBEU, BIL, BND, BSV, DEM, DIA, DXJ, EEM, EWG, EWI, EWJ, EWP, EWQ, EZU, FEZ, FXI, GBIL, GEM, HEDJ, HYG, IEMG, IEUR, IEV, IVV, IWM, JNK, LQD, MCHI, QQQ, SCHE, SCHO, SHV, SHY, SPEM, SPY, STIP, TLT, VGK, VGSH, VOO, VTI, VWO, XLRE, XLU
by: The Fortune Teller
Summary

While stocks have rallied over 20% since their December lows, the US 10-year Treasury yield has actually fallen by 4%.

Not only that the partially-inverted yield curve isn't fading away, but it's actually spanning all the way up to 7-year debt.

In spite of the 30-10 spread steepening, the most important 10-2 spread is persistently maintaining a close distance from the zero level.

Bonds, yields, and spreads in other major economies aren't looking any better. If anything, they only add few more worries to the mix.

The "Smart Money": Danger Ahead!

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As I've already outlined many times before, most recently here, bonds (AGG, BND, LQD, BSV, TLT, HYG, JNK) are a much better indicator/gauge for the health of an economy than stocks (SPY, DIA, QQQ, IWM, IVV, VTI, VOO).

High-yield bonds moving with the ebbs and flows of US earnings announcements tend to predict stock returns for a slew of issuers, particularly firms with a modest level of institutional equity ownership. So stock investors seeking an informational edge should keep their eyes on junk bond prices on the heels of earnings reports.

That's the conclusion of a paper published in the Journal of Accounting and Economics in August 2017 by Omri Even-Tov (an assistant professor at the Haas School of Business) of the University of California at Berkeley.

Mr. Even-Tov took a look at the bond returns that followed a whopping 19,518 quarterly earnings announcements of 770 firms from 2005 to 2014.

The bond price reaction provides incremental explanatory power for post-announcement stock returns over and above the information contained in the earnings surprise (the post-earnings announcement drift), the level of reported accruals (the accruals anomaly), and the immediate stock price reaction to the earnings announcement.

This suggests that the sophistication of bond traders relative to stock traders is a driver of the ability of bond returns to predict post-announcement stock returns - Omri Even-Tov

Chart Data by YCharts

While Short-Term Yields Are Making New Highs, Long-Term Yields Are Making New Lows...

In case you've missed it, last Friday (March 15th), the 1-month Treasury yield (BIL, SHV, SHY, VGSH, SCHO, STIP, GBIL) hit a new 11-year high at 2.48%.

Of course, much of this move only took place over the past three years, yet this very short-term yield reaching a level we haven't seen since early 2008 is not something that should be taken lightly.

Thing is that while the 1-month Treasury yield is making a new high, the 10-year Treasury yield is making a new low. As a matter of fact, US 10-year Treasury yields are back to the lows of the year, around 2.58%, down from 3.25% in November 2018!

Last week's 30-year Treasury auction has met a bit muted demand, yet the 10-30 year US yield curve has steepened to the the widest since late 2017.

The current 30-10 year Treasury yield spread is about 42.5 bps, which make some investors believe that the worst is over.

Well, not so fast...

First of all, the most important spread to focus on is the 10-2 year Treasury yield spread, which is still at extremely distressed levels, and only 16 bps above the inversion point.

Chart Data by YCharts

Secondly, if we look at the shorter end (less than 10-year) of the yield curve - where things are more dynamic and reflective of the economy as well as the foreseeable future - there's nothing to be too cheerful of.

Partially Inverted Yield Curve

The yield curve has been partially inverted for few months now! To put things in the right, not so encouraging, perspective, here are few examples:

  • At 2.46%, the 3-month Treasury bills have a higher yield than the 5-year Treasury notes.

  • At only 14 bps, the spread between the 10-year and 3-month Treasury yields is the narrowest we've seen since September 2007!

  • With 6-month Treasury yield trading 3 bps higher than the 7-year Treasury yield, this is now only the most inverted US yield curve we've had since September 2007, but something that happened only twice over the past 25 years! And just to be clear about it: Neither of these two previous times brings good memories...

Here is how the most inverted US yield curve since September 2007 looks like:

  • 1-month Treasury yield: 2.46%
  • 3-month Treasury yield: 2.45%
  • 6-month Treasury yield: 2.52%
  • 1-year Treasury yield: 2.52%
  • 2-year Treasury yield: 2.43%
  • 3-year Treasury yield: 2.39%
  • 5-year Treasury yield: 2.40%
  • 7-year Treasury yield: 2.49%
  • 10-year Treasury yield: 2.59%
  • 30-year Treasury yield: 3.02%

Bonds and Yield-Sensitive Sectors Benefit

The partially inverted yield curve certainly assists in boosting investors' level of comfort in holding bonds going forward.

The sum of all fears among those buying investment-grade and high-yield debt has sunk to its lowest level since 2014, according to Bank of America's March survey of fund managers.

Another more positive sign for US high-yield bonds, even after this year's 6% rally year to date, is the duration.

A measure of duration on the Bloomberg Barclays High Yield index has fallen to the lowest in decades, meaning that the debt is less sensitive to moves in benchmark rates.

With such a flattish yield curve, it's no surprise that the best performing sectors over the past year are Utilities (XLU) and Real Estate (XLRE).

Both sectors hit new all-time highs last week.

Fear, aka Negative-Yielding Debt, is Back

It's not only the low yields of the long-end of the curve, or even the partially inverted yield, signaling that danger is ahead.

In case you've missed it, the global u-turn in central banks' monetary policies has pushed the amount of outstanding negative-yielding debt above $9.2 trillion.

We were sub-$6 trillion less than six months ago...

Let's zoom in and take a closer look at the pool of negative yielding debt, which is based on the market value of Bloomberg Barclays Global Aggregate Negative Yielding Debt index.

Not only that the $9.2 trillion is a new post-2017 high, but it's mind boggling to see such a high level at a time when the global economy is supposedly still recovering.

Not Looking Good for the Rest of the World Either

There's an upstart take on China's (MCHI, FXI) official rating agencies on the heels of growing concerns over defaults by high-rated issuers.

2018 saw a record number of Chinese corporations default, out of which some were rated AAA.

Although the 10-year Japanese (EWJ, DXJ) yield has stayed above zero since 2017, the trend over recent months is clearly down and we are getting close to sub-zero levels fast.

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The growth of the Bank of Japan’s balance sheet dwarfs that of both the ECB and Fed (which actually withdraws liquidity from the market recently). The BoJ is among the largest stakeholders in virtually all Japanese listed companies and it also owns 43% of all outstanding government debt.

The "Japanification" narrative is strengthening in Germany (EWG), with the ECB's "lower for longer" interest rate policy.

10-year German Bund yields are on course to zero, their lowest level since 2016. Bund yields over the past 15 years (since 2004) continue to (scarily) mimic JGB's yields between the late 1990s to the early 2000s.

When it comes to loan growth to non-financial corporations, the Eurozone (VGK, EZU, HEDJ, FEZ, IEUR, BBEU, IEV) is highly fragmented.

Credit growth differentials between Germany/France (EWQ) vs. Italy (EWI)/Spain (EWP) have just hit a fresh high.

With inflation slowly but surely fading away, there's a glimmer of hope even for Emerging Markets ("EM"; VWO, IEMG, EEM, SCHE, SPEM, DEM, GEM) as the bond rally peters out.

However, before we celebrate EM looking like developed markets (...), it's important to remember the wall of debt that many EM issuers are facing, specially the most vulnerable ones, in years to come

Few More Worries

1. The share of US credit owned by foreign investors has been declining recently. If the appetite for US debts by non-US investors will keep shrinking, that might send long-term yields higher, even if the economic data won't support this trend.

2. The share of BBB-rated corporate debt has grown 400% since 2007!

Since BBB is an investment-grade rating, the overall quality (i.e. average risk rating) of the investment-grade spectrum is deteriorating.

3. Based on the US budget office estimates, the US government total debt, as a percentage of GDP, is expected to skyrocket from here.

The post WWII record-high debt-to-GDP ratio of over 100% is going to get smashed in a matter of a decade or so, max.

Bottom Line

The "smart money", that is what's going on in the bond market, is speaking a completely different language than the stock market.

In such a time, when stocks have been rallying over 20% from their lows, in less than three months, the 10-year US Treasury yield isn't "supposed" to move down 4%, as it did.

While stocks have been rallying over 20%, in less than three months, the 10-Year US Treasury Yield has fallen by 4%.

Neither the yield curve, all the way up to 7 years, is supposed to invert.

True, the 10-2 year spread is still holding above the zero level. However, as you can see below, it's persistently trading flat, hovering in the teens (basis points), even when the 30-10 year spread has almost doubled.

Chart Data by YCharts

The way I interpret the bond market these days, isn't only as a "danger ahead" warning call, but as a clear signal that the economic growth is going to slow significantly, just like the Atlanta Fed's GDPNow is forecasting for Q1 2019 (Latest forecast as of March 13th, 2019: 0.4%).

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.