Yield curve warning signs

[brewer12345]

I notice that the yield curve has become very flat, with under 50BP between the 2 year and 10 year treasuries. Historically, an inverted yield curve has strongly suggested that the economy is about to g into recession. I don't necessarily read the tea leaves that way right now, but it has caused me to re-assess. If we are, in fact, likely to see a significant economic slowdown or even a recession, the equity markets will get hit, given the fairly generous earnings growth embedded in current prices. The easiest way to play this would be a put on the index ETFs.

Any thoughts here? I don't think we are headed for recession. Consumer spending remains healthy, business investment looks OK, capacity utilization is the highest it has been in some time, inflation is apparently under control (quibbling aside), and companies are actually spending some of their hoarded cash. Like I said, I don't see a recession coming, but a gut check is in order.

 

[wildcat]

Certainly walking a fine line.  Puts would be a good hedge.  I really don't know of any exceptional asset plays given the potential slow down and current valuation environment. Do you follow leading indicators index or any other economic reports?

 

[retire@40]

I don't see a recession coming either (too soon).  I think the most important factor in the economy will be inflation.  Inflation and a corresponding rise in long-term rates will turn this economy around.

Sales of new homes hit an all-time high last month, and that scares me.  The cost of buying a home is taking a larger percentage from peoples' disposable incomes.  Then, people are charging much more on their credit cards to meet their other demands.  I'm no economist, but I would think that would eventually cause people to demand higher wages, thus causing inflation.

Once we are in an inflationary period, long-term rates will be higher and will cause a decrease in the sales of homes, less money placed in equities, and an eventual recession.

 

[wildcat]

Don't you guys think given other asset plays equities are still up there as one of the best even though the valuations are not cheap historically. Where else do you put money to work?

Brewer I absolutely agree with the cash heavy balance sheets. Dividends are moving up and we will see M&A activity. Dividends moving up enough could help boost returns to a moderate level. So I still say be exposed to dividend stocks via ETFs and index funds.

I may stand corrected but from what I know many of economic reports suggest we are not headed for a recession. Eco reports can be somewhat accurate several months in advance.

 

[brewer12345]

I usually discount economic indicators and economists' projections. There is an old saying: "economists have predicted 9 out of the last 5 recessions."

 

[REWahoo]

There is an old saying: "economists have predicted 9 out of the last 5 recessions."

Economics is known as "the dismal science" for a very good reason...

REW

 

[Marshac]

I too have been keeping an eye on the yield curve. It's interesting to note that parts of the curve have already inverted, namely the overnight rate (3%) vs the 1mo (2.8%) and 3mo (2.99%) rates.

http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.html

Another 25bp hike will take the overnight rate out past the current 6mo rate, and near the 1 year rate. With an increasing the foreclosure rate, decreasing sales volume in the 'bubble' areas, stagnant M3, and a contraction in manufacturing in the NY area (and a slowdown overall), I believe that a recession is probably in the cards for 2006.

If you want to see one possible future, look towards the UK. I believe they started hiking rates about 6mo before our feds did.


Home sales volume:
http://www.dqnews.com/ZIPLAT2004.shtm

 

[wildcat]

portions of Smarty Marty Whitman's latest q report.

"Given the build-up in TAVF’s cash position — cash and
equivalents amounted to $778 million at January 31,
2005 — it seemed prudent to partially hedge against the
possibility that the U.S. Dollar might decline dramatically
against other currencies in the months just ahead. This
course of action seems particularly appropriate since it
seems probable that the Fund will continue to invest in
foreign securities denominated in foreign currencies.
During the quarter, Third Avenue invested $100 million
U.S. Dollars in Pound Sterling and $100 million U.S.
Dollars in Kiwis. The reasons for acquiring Pound
Sterling and Kiwis are that they seem to carry no credit
risk, they are short term, and they carry the highest yields
among quality credit government debt — about a 4.5%
annual rate for Pound Sterling and an annual rate of
around 6.5% for the Kiwis. The risk to TAVF is a capital
risk — the possibility that the U.S. Dollar will appreciate
in value versus Pound Sterling and Kiwis. This seems a
sensible risk to take under the circumstances.

The fact is that all of the Fund’s equity investments made
during the quarter were in foreign equity securities and
the equity security of a U.S. business that has a huge
presence overseas, AVX. TAVF has no prejudice against
investing in the U.S., and indeed, other things being
equal, would prefer to invest in this country. However,
The U.S. is a mixed economy combining many
weaknesses and strengths with, in my opinion, a tilt more
toward strength than weakness. In brief, weaknesses and
strengths seem to shake out as follows:
Major Weaknesses
• Badly financed federal, state and local governments
where much of the use of proceeds from borrowings
seems to be non-productive.
• A badly financed consumer sector where much of the use
of proceeds from borrowings seems to be non-productive.
• An ultra high cost manufacturing sector with resultant
trade imbalances.
Major Strengths
• Best capital markets that have ever existed.
• Very strong banking system, soundly financed.
• Lowest cost distribution system in the world.
• Diversified economy.
• Entrepreneurial population, well educated.
• Relative political stability.
• Corporations generally seem comfortably financed —
at least those with publicly traded securities."

http://www.thirdavenuefunds.com/1Q05.pdf

 

[cute fuzzy bunny]

ECRI's leading economic indicators appear to show that we're currently near a recessionary level. Their numbers appear to not jibe with the govts figures. Their predictive inflation indicators show a very slowly increasing upward slope.

To me, all of this screams keeping a good portion of your money in cash, short bonds and/or very value-ey equities.

 

[Nords]

Any thoughts here?  I don't think we are headed for recession.  Consumer spending remains healthy, business investment looks OK, capacity utilization is the highest it has been in some time, inflation is apparently under control (quibbling aside), and companies are actually spending some of their hoarded cash.  Like I said, I don't see a recession coming, but a gut check is in order.

Agreed that it'd take a substantial shock to send the U.S. back into recession. But it's also just too easy for that shock to take place.

We're exploiting the yield curve with mortgage money. We refinanced last Oct at 5.5%, the lowest rates in 40 years. Yesterday we started the process again at 5.375%, absolutely the lowest rates in 40 years (and this time I really mean it). If we can hold down the closing costs to our previous refinance then the payback is about 32 months (instead of the six months on the last refi) but... we'll be paying less money on a mortgage that's almost at five-year CD rates. Works for us!

 

[Marshac]

To me, all of this screams keeping a good portion of your money in cash, short bonds and/or very value-ey equities.

I went to about 50% cash, 20% bonds, 30% equity last week... quite a change from the 90% equity portfolio I had before. If i'm wrong, I doubt I will lose much in terms of cap gains in the months ahead, and if I'm right, I won't be kicking myself for not having the balls to change my portfolio mix.

 

[wildcat]

playing it cool at 80/20 equities/bonds

 

[cute fuzzy bunny]

Marshac - probably a good move.

Wildcat - good luck.

 

[wabmester]

Historically, an inverted yield curve has strongly suggested that the economy is about to g into recession.

Let me see if I understand the underlying assumptions here.   Historically, bond demand has been driven by investors.    So, when FI investors are bearish about the economy, the demand for longer-term debt drops, and they stay short-term.    Is that the logic that supports inverted yield curves as a predictor of recessions?

So, help me out here.   My impression is that the bond market is no longer driven by investors, as it once was.    Today, the largest drivers for the 10-year are guys like Fanny Mae and foreign central banks, right?

If that's true, can't you explain the flat/inverted yield curve in terms of supply and demand?   Mortgage demand is still strong, so FNMA et al are still buying the 10-year as a hedge.

But I've heard that China and Japan have cut waaaay back on their purchases of our debt, and I assume that our supply is still increasing, so I would have expected longer-term rates to increase in these conditions.

In short, I'm a bit confused, but I don't have hard data.    But I think it's too simplistic to view the yeild curve with the same economic predictive power it may have once had.

 

[brewer12345]

Let me see if I understand the underlying assumptions here.   Historically, bond demand has been driven by investors.    So, when FI investors are bearish about the economy, the demand for longer-term debt drops, and they stay short-term.    Is that the logic that supports inverted yield curves as a predictor of recessions?

So, help me out here.   My impression is that the bond market is no longer driven by investors, as it once was.    Today, the largest drivers for the 10-year are guys like Fanny Mae and foreign central banks, right?

If that's true, can't you explain the flat/inverted yield curve in terms of supply and demand?   Mortgage demand is still strong, so FNMA et al are still buying the 10-year as a hedge.

But I've heard that China and Japan have cut waaaay back on their purchases of our debt, and I assume that our supply is still increasing, so I would have expected longer-term rates to increase in these conditions.

In short, I'm a bit confused, but I don't have hard data.    But I think it's too simplistic to view the yeild curve with the same economic predictive power it may have once had.

As I understand it, recessions tend to result in two things: 1) inflation drops, and 2) the Fed lowers rates to stimulate the economy. Both of these would strongly suggest that beoing in the longer end of the yield curve will be profitable. Simple as that. If you see the yield curve invert, market consensus is that there is likely to be a recession.

Going totally into cash is too extreme for me, even if I knew that we were going for sure. Instead, I would sell off anything highly dependent on heavy growth (which I have done), move cash/bond holdings a little further out on the curve (done), and now I am considering a longer-dated SPY put as an equity market hedge. Still not quite convinced, though.

 

[Michael]

The politicians have historically tried to get the pain over in the first 2 years of a President's term, so that the market would be booming in the 2 years leading up to the next election. I don't see any reason to think that this time will be different.

 

[retire@40]

I went to about 50% cash, 20% bonds, 30% equity last week...

Sounds like an allocation for a 55 year old, not a 25 year old.

 

[Marshac]

Sounds like an allocation for a 55 year old, not a 25 year old.

For a normal 25 year old that wants an auto-pilot portfolio, perhaps... I'm a little bit more active in moving my money around. Two years ago I was 100% equity, 30% of that in the Russell 2000, and an another 30% international fund... I did pretty well.... now I feel as though the prudent move is to batten down the hatches a bit. We will see

When i'm convinced the worst has past, I will be all in again, I assure you

 

[wabmester]

As I understand it, recessions tend to result in two things: 1) inflation drops, and 2) the Fed lowers rates to stimulate the economy.  Both of these would strongly suggest that beoing in the longer end of the yield curve will be profitable.  Simple as that.  If you see the yield curve invert, market consensus is that there is likely to be a recession.

Oops, right -- I had the investor demand part of the equation backwards.

My poorly stated question was: are investors still driving bond prices?    My impression is that the bond demand from traditional investors is completely swamped by demand from foreign central banks and by FNMA.

My (poor) understanding is that in recent years, the mortgage-backed security market has become an 800-lb gorilla.   Demand for treasuries is largely driven by hedging interest rate risk on those securities.    And foreign central banks (esp Japan and China) hold some huge percentage of our debt (around half?), making them the other huge driver of treasury bond prices.

So, does it still make sense to look at the 10-year as a gauge of investor sentiment?

 

[brewer12345]

Oops, right -- I had the investor demand part of the equation backwards.

My poorly stated question was: are investors still driving bond prices?    My impression is that the bond demand from traditional investors is completely swamped by demand from foreign central banks and by FNMA.

My (poor) understanding is that in recent years, the mortgage-backed security market has become an 800-lb gorilla.   Demand for treasuries is largely driven by hedging interest rate risk on those securities.    And foreign central banks (esp Japan and China) hold some huge percentage of our debt (around half?), making them the other huge driver of treasury bond prices.

So, does it still make sense to look at the 10-year as a gauge of investor sentiment?

Foreign central banks and FNM are investors, traditional or not. I think that Fannie really only crowds into the bond market when we go into refi booms. AFAIK, we aren't in one at the moment.

There are still plenty of "traditional" investors buying teasuries. Pension funds need longer dated bonds and last I checked, PIMCO's bond funds are still popular.

 

[wabmester]

Foreign central banks and FNM are investors, traditional or not.  I think that Fannie really only crowds into the bond market when we go into refi booms.  AFAIK, we aren't in one at the moment.

Do you know where I can find numbers on who's buying the treasuries? My impression is that a lot of the buying is pretty mechanical. We buy a bunch of crap from China. China says "what the hell are we going to do with all these dollars?" and they give them back to us to buy our debt. There is no consideration about interest rate futures.

And I'm still unclear about how FNMA hedges their risk, but don't they basically buy treasuries whenever they sell an MBS? I'm sure it's not 1-1, but I think you only see them as a seller of treasuries during a refi boom because they have to sell treasuries to call their MBS's.

 

[haha]

Let me see if I understand the underlying assumptions here.   Historically, bond demand has been driven by investors.    So, when FI investors are bearish about the economy, the demand for longer-term debt drops, and they stay short-term.    Is that the logic that supports inverted yield curves as a predictor of recessions?

Whatever the logic may or may not be, a flat yield curve knocks the crap out of carry-trades, and damages profitability at many banks and financial companies. So that might be an instrumental, rather than just correlative relationship.

H

 

[brewer12345]

Do you know where I can find numbers on who's buying the treasuries?   My impression is that a lot of the buying is pretty mechanical.   We buy a bunch of crap from China.   China says "what the hell are we going to do with all these dollars?" and they give them back to us to buy our debt.   There is no consideration about interest rate futures.

And I'm still unclear about how FNMA hedges their risk, but don't they basically buy treasuries whenever they sell an MBS?    I'm sure it's not 1-1, but I think you only see them as a seller of treasuries during a refi boom because they have to sell treasuries to call their MBS's.

Maybe the Treasury keeps tabs on who the buyers are?  I don't know for sure.

I'm not sure how to describe this adequately without getting too technical, but Fannie does some buying of treasuries and treasury derivatives when a refi boom goes on.  The fixed rate loans Fannie makes leaves them short convexity (second derivative of bond prices with respect to rates).  By taking positions in treasury derivatives, they effectively buy back this convexity.  When they have to do it in massive size, they are big enough to move the treasury market (like back in '03).  If borrowers in the US didn't insist on 30 and 15 year fixed rate mortgages, it wouldn't be so much of a problem.  That is why this issue is unique to the US AFAIK.

 

[wabmester]

... leaves them short convexity (second derivative of bond prices with respect to rates).

Zzzzz. Thanks for trying, though.

 

[ronin]

I suspect hedge funds have a bazillion leveraged $$$ in treasuries, but short a couple of them blowing up or melting down I don't know how you'd find out the extent of their involvement.