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What's In Your Wallet - US Treasuries Or German Bunds?

Summary

The brief inversion of the U.S. yield curve could signal dark clouds on the horizon for equities as well as for the economy.

However, it is not clear how investors should prepare for an event when the timing is elusive - are they ready to give up on potentially lucrative returns?

Negative yields in Europe may explain the recent rush into U.S. treasuries and may be in part responsible for the inverted yield curve.

After all this talk about an inverted yield curve last week, we should probably take an excursion into the Bond Market to see what the fuzz is all about. The yield curve is a visual representation of U.S. government bond yields at different maturities a.k.a. term structure of interest rates. U.S. treasuries come in short-term treasuries maturing in one month all the way to long-term bonds maturing in 30 years.

A normal yield curve is upward sloping so that longer maturities have higher yields than shorter maturities – a basic principle of the time value of money. Market observers focus primarily on the spread between the 10-year Treasury and the 2-year Treasury as an indication of a normal versus inverted Treasury yields. The same observers would also tell you that an inverted yield curve is an omen of bad economic times ahead and they point to the fact that the past recessions since 1980 have been preceded by an inverted yield curve. The chart below, courtesy of the Federal Reserve Bank of St. Louis, shows how the spread between the 10-year and 2-year T-notes turned negative prior to each of the past 5 recessions.

Source: 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity - Shaded areas indicate U.S. recessions

Given the recent market turmoil and a brief inversion of the yield curve, two questions might be on your mind: 1) are we in for another recession and 2) is this signaling the end of a decade-long bull market?

The two questions are related but need to be assessed separately.

In terms of the U.S. economy, there is little evidence domestically that a recession is around the corner. A strong labor market and the confidence of U.S. consumers show no signs of a slow-down just yet. There are of course external risk factors including the trade war with China, Brexit and a general slow-down in Europe that will affect U.S. companies doing business overseas. U.S. consumers might also be affected by higher prices when tariffs on a majority of Chinese goods come into effect. As the chart above depicts, however, prior yield curve inversions also included time lags between the inversions and the following recessions. Before the last financial crisis, we had an early signal from a negative yield curve in December 2005, albeit the recession officially started only about 2 years later. Then there are potentially false signals like the brief inversion in June 1998 when the 10-2 year spread was at negative 0.05%. The jury is still out as to whether the most recent yield curve is a very early signal or whether it is perhaps a strong warning of what’s ahead. What we can say is that each of the past 5 recessions was also preceded by a multi-year long, in some cases over a decade, protracted decline in the 10-2 year spread. Will history repeat itself now or will this time be different?

Let’s look at equities to get a different perspective. The stock market is not the same as the economy but it can be a predictor of what’s ahead since investors make decisions based on expectations. Is the U.S. stock market showing signs of an upcoming bear market? Here’s a look at the past few decades to a get sense of how stocks fared after yield-curve inversions.

Source: Daily Treasury Yield Curve Rates and author’s calculations.

If history is any guide, while acknowledging the small sample size, it is conceivable that we are entering the end of a long bull market. As investor expectations become less optimistic, they take risk-off and increase their fixed income allocations, the safest one of them being U.S. treasuries and the most liquid perhaps the 10-year T-note. As more investors rush into treasuries, bond prices go up and yields go down which, in some rare cases, can cause a yield curve inversion. And just to be clear, it’s not the yield curve that’s causing a recession or a stock market decline but the yield curve is simply a symptom of investor expectations. Evidence of an increasing investor wariness also shows up in the new record low yield of the 30-year T-bond at just slightly above 2 percent. Having said that, it is not at all clear how an investor can prepare for an event such as a recession of a bear market when the timing of the event is elusive – will you stay out of the market for potentially 12-18 months and give up on potential upside?

To put things into perspective though, look no further than across the Atlantic where the entire German yield curve turned negative recently.

Source: https://www.bloomberg.com/markets/rates-bonds/government-bonds/germany

By contrast to negative yields in numerous European countries, one thing that keeps U.S. Bond prices high and hence yields low is the relative safety and massive liquidity of U.S. fixed income markets. If you had a choice between a German 10-year government bond with a negative yield or a U.S. treasury with a low but still positive yield, what’s in your wallet?

So perhaps a big part of the reason why the U.S. yield curve turned negative is an increasing skepticism of the continuation of this record bull run in equities along with fears of a recession. But it may at least in part be caused by outside investors and institutions who are perhaps even more pessimistic about their own country’s economic prospects and chose a small but still positive yield in favor of paying for the privilege of lending to their governments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.