Notes From the Rabbit Hole

The Yield Curve in the News

[edit] See also Steve Saville’s discussion of the yield curve.

Well, after one down day in the markets why not put up a cautionary article? Quick! Scour the internet… who’s got a warning we can flash?

Ah, Gundlach. Okay, pump this out there and harvest as many eyeballs as possible before the market rallies again and we’re looking for stupid bull bromides!

Why the yield curve flattening — a recession red flag — is the ‘real deal’

As discussion swirls over whether the bond yield curve’s flattening represents the portents of a recession, bond market notable Jeff Gundlach of DoubleLine Capital weighed in on the debate, calling the recent phenomenon the “real deal.”

Actually, I agree Jeff.

Gundlach takes issue, in large part, with those questioning the value of this economic barometer by pointing to foreign demand alone as pushing the curve flatter, he said in an interview with CNBC.

Agree again, Jeff. But foreign demand is no doubt in there.

More importantly, fears of a curve inversion, or when long-dated yields are lower than short-term yields, is what has drawn eyeballs of late, as the phenomenon is seen as an eerily accurate predictor of a future recession. That’s because the curve tends to invert in response to a combination of slowing growth expectations (hitting the long end) and tighter monetary policy (hitting the short end), both factors capable of derailing an economy at the tail end of its expansion.

MSM is drawing eyeballs with that thesis. Inversion or no inversion, a flattening curve runs with a boom (in this case more asset oriented than economy oriented) and its end point – whether with the curve still to the plus side, flat or inverted – signals the end of the boom. The curve can begin to steepen under pains of economic deceleration or inflationary intensification.

The long-term picture shows that the curve has had a slight upward (steepening) bias since the end of the last real (my bias instructs that everything post-2000 has been manufactured largely through bond manipulation) secular bull market in stocks. It need not flatten or invert in order to halt the trend, although that is certainly possible. I am watching this 3rd Amigo closely along with Amigos 1 (stocks vs. gold) and 2 (nominal long-term yields) for signs of confluence to the boom’s end. Here was our last public update on the Amigos.

Back on topic, the article on balance is actually a sound piece of writing (got to give credit where it’s due, and so the featured image for this post will not be the usual ‘MSM clowns’ graphic, but the headline writer needs a clown face) and notes some helpful reasoning by Gundlach as to why the flattening curve is a concern. Ultimately, what it serves to do is reinforce my argument that our job as market managers is to TUNE IT ALL OUT and simplify. The curve is flattening… that is all you need to know. Then you combine and cross reference it with other indicators and you are good to go.

Gundlach, however, felt that argument doesn’t hold water. It would imply bond buyers were snapping up debt without hedging for currency movements. With the dollar weakening for much of the year, buyers of Treasurys who chose not to lock in the currency rate would have lost all their gains by the falling greenback.

Moreover, Japanese investors, a significant player in the market for U.S. debt, found it made more economic sense to buy European bonds over U.S. counterparts thanks to the high cost of hedging currencies, said Joakim Tiberg, a global macro strategist at UBS, in a previous interview with MarketWatch.

Gundlach pointed out that previous attempts to look past the yield curve’s predictive abilities have ended poorly. The last time the curve inverted, a few market participants said China’s central bank’s accumulation of bond purchases had contained long-term yields even as rates rose in 2004-2006.

Yet the People’s Bank of China would have been amassing short-term debt, which should have instead led to a steepening of the curve, not a flattening, he said.

History has been replete with well-respected central bankers unperturbed by those who see the indicator as a bond market Cassandra. Former Fed Chairman Ben Bernanke said in a speech to the Economic Club of New York in 2006 that a global saving glut had kept long-term yields low.

The article ends with more sound discussion. When the curve does stop flattening, it’s not like an alarm bell is going to ring immediately. We are noting the negative signals from the Semi sector for 2018, but recalling the 2013 positive signal, it took literally years for that signal to become a generally accepted (positive) economic reality. We also noted recently, either by NFTRH update or in a report, that at the point of curve inversion and upturn, it can still be many months before the macro markets change trends. So… caution, risk management and temperance, but never panic.

Other bond market analysts agree that though an inverted curve was worrisome, it did not ring alarm bells for next year.

“Just because the yield curve is flattening, or even gets inverted, doesn’t mean suddenly we’re going to jump into a recession. It’s a good indicator of what we might see down the road, but it doesn’t mean it’s imminent,” said Collin Martin, director of fixed income for the Schwab Center for Financial Research. “We don’t expect a recession in 2018; it’s most likely a couple years out.”

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