10-Year - 2-Year Near Inversion, Mispricing Of Reality, And A Buy The Dip Opportunity, Just Like 1995

by: ANG Traders

The temporary 10y-2y inversion which occurred last week is similar to what happened in 1995, and not a warning of imminent recession.

Monetary and economic conditions were similar in the mid-to-late 1990s to those of today.

The bond rally (yield collapse) is the result of the worldwide search for yield, not because a recession is imminent.

We see this as a mispricing of reality and a buy-the-dip opportunity, just like it was in 1995.

Judging by the amount of fear being promulgated by more or less the entire media complex, nobody seems to understand the unique situation we are in.

The truth is, we know so little about life, we don't really know what the good news is and what the bad news is (Kurt Vonnegut in his influential lecture on the shapes of stories)

We have a signed bipartisan spending agreement with no debt ceiling to prevent further spending if desired... AND it is an election year, when spending generally increases!

In this piece, we will argue that the 10y-2y (temporary) inversion is more similar to what happened in the mid-1990s - which produced five years of stock market gains - than it is to any other time when recessions followed.

Last Wednesday's pre-market 10y-2y rate inversion, which only lasted 2 hours, sent the entire investments universe into a very dark space filled with nightmares of recession. Never mind that, even when there is an inversion (which there is not, at this point), recessions take up to 24 months to materialize. And never mind that all of the various inversions that are currently in place have occurred because the longer-end of the curve has decreased more than the short end, not because there is a fear of short-term lending arising from weak economic conditions.

The bond rally (yield collapse) is the result of the worldwide search for yield, not because a recession is in the neighborhood. Despite a decent economy and guaranteed Federal government spending about to be unleashed, a significant majority of investors are irrationally scared and fleeing to the safety of bonds.

In an update to our subscribers during the week, we showed how the present situation is very much like the mid-1990s.

The similarities between 1995 and 2019 are several:

  • FFR stabilized after rising for more than a year.
  • The 10y-2y collapsed, but did not invert.
  • The stock market was making new highs.
  • The economic conditions were moderately good and not raising any flags.

The chart below shows the long-term view of the 10y-2y rate curve, the Fed funds rate, and the SPX. The green highlighted areas are the pertinent time-periods.

Source: ANG Traders, stockchartspro

The chart below shows a close-up of the 1995 near inversion. There was a sharp drop in the 10y-2y as the Fed funds rate (FFR) was stabilizing, similar to what is happening today.

Source: ANG Traders, stockchartspro

The chart below shows a close-up of the recent time frame. Here, like in 1995, we have the FFR stabilizing and the 10y-2y dropping but not inverting. Although much has been made of the inversion, it inverted for only a few hours (pre-market), and it recovered before the regular opening. The quick slide to a temporary inversion was likely exasperated this time by algo trading, which was much less prevalent in 1995 and may explain why it came closer to inversion this time than in 1995.

Source: ANG Traders, stockchartspro

We think that the 10y-2y will remain positive as the FFR is reduced and stabilized, like occurred during the mid-to-late 1990s, and that a true inversion will be delayed for at least a year. We also have to point out that, even when the rates invert, a recession does not form for 12 more months, on average. This means that the market's reaction to the dropping yield differential was an over-reaction.

The economic conditions during 1995 and today are also very similar. There were no warning flags then, and none today.

Banks tighten loan conditions for commercial and industrial loans when economic conditions weaken and banks attempt to reduce risk. In both 1995 and during the past several quarters, banks tightened their loan standard, then loosened them again as conditions improved (green highlights below).

Consumer sentiment dipped in 1995, and it has dipped recently (chart below).

Delinquency rates on commercial and industrial loans were historically low, in both time-periods (two charts below).

Industrial production, in both time-periods, showed a slow-down, but the slowdown was not disastrous then, or now (two graphs below)

Housing starts, after having risen for several years, showed a temporary slowdown in both time periods (two charts below).

The temporary (two hour) inversion of the 10y-2y differential has been taken up by the media and the trading algorithms as a sign of economic Armageddon despite there being only moderate reductions in the underlying economic fundamentals. The situation parallels the mid-to-late 1990s, which led to five years of higher stock valuations. We see this as a case of mispricing reality and a "buy-the-dip" opportunity.

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.