Are there any clues that might foreshadow a slowdown in economic growth and therefore corporate earnings? It turns out there may be. An inverted yield curve refers to a situation whereby the cost of borrowing for a long period of time decreases below the cost of borrowing for a short period of time. This phenomenon is relatively rare because lending money for long periods of time is inherently riskier as the value of long-term bonds can fluctuate, sometimes materially, with changes in interest rates. A bond investor must be compensated for this additional risk. When the yield curve becomes inverted it is a signal that interest rates may decline in the future. A shift in interest rates large enough to invert the yield curve could also signal that economic growth will slow and/or inflation will decline.
The chart below shows that an inverted yield curve preceded the last three recessions (depicted by the gray shaded areas). The chart also shows that the yield spread between the 2- year and 10-year Treasuries has decreased dramatically over the past several years. Is the bond market trying to tell us something? It could be. But there could also be other factors causing the 10-year bond to remain in high demand. The most compelling explanation might be that the yield spread between the 10-year US Treasury and the 10-year German bund has become quite wide. Investors may be using the large spread to arbitrage by buying the 10-year US Treasury and shorting the 10-year German bund. Time will tell.
The chart below shows that the Fed’s seven quarter-point interest-rate hikes to date have led to a much steeper increase in the 2-year yield as compared to the 10-year yield. As a result, the yield spread has decreased from about 1.25% prior to the first rate hike in December, 2015, to just around 0.30% as of this writing. Why would anyone take the risk of owning a 10-year Treasury at 2.85% if you can get 2.55% by purchasing a 2-year Treasury? Somebody thinks the rosy 3%-4% GDP growth scenarios aren’t coming anytime soon.
On another topic, it seems like a sort of “Trump put” is being put in place. Each time President Trump or one of his representatives says something that is unfriendly to the markets, the markets predictably swoon and then we get President Trump or one of his representatives coming out and walking back the prior statement. In our view, there is little doubt that stock investors have become emboldened by the President’s obsession with stock prices.
What is even more interesting, though, is that there seems to be a “Trump call” developing as well. Each time investor confidence improves and stock prices start to head higher, President Trump or one of his reps comes out and says something that is market unfriendly (most frequently, hawkish trade rhetoric). We didn’t like the notion of a Fed put, and we certainly don’t like the notion of a Trump put or call. As investors, we’d like to get back to free markets, with as little influence from monetary policy and politics as possible!