Yield curve getting flatter, and flatter

[cooch96]

Thoughts?

My thoughts are the US economy is in the very beginning of a stagflation cycle, albeit mild. I also suspect bonds are going to fail at keeping pace with inflation. I’ve been saying that for years now, so eventually I’ll be right.

My plan is to stay heavily weighted in equities, drop bonds as soon as I leave megacorp and get more control of my retirement funds, and keep some cash in short term (6-18mo) cd’s.

 

[cooch96]

You are seeing the future?

Knowing the Years is hard! I’ll fix it. Thank you.

 

[njhowie]

I need to rebalance some $$$ from equities into bonds. Choices are bond funds, cd's from brokerage or treasuries. Money not needed for 8 years or more but I can't decide on how long to go out. Doesn't seem to be any advantages going long?

With rates the way they are today, when you buy long term, you are buying insurance ... against rates going lower. You should consider that if you buy a 2-year bond/CD/treasury today, how will you reinvest at maturity if rates have gone lower? 2.6% for 2-year or 2.75% for 3-year might look pretty good when 5-year is at 2.95%. However, in 2 or 3 years, when it matures and you want to reinvest, what if the rates for those maturities are back down around 1.0%?

For any money where you've decided on CDs/treasuries the choice is quite simple - treasuries for anything up to one year, CDs for anything longer. However, for maturities over 10 years, CD pickings are quite slim.

 

[audreyh1]

Even though bits of the yield curve have inverted, the 10 year is not below the 2 year or 3 month yet.

The yield curve can be close to flat for a very long time.

When/if the 10 year finally does revert, then some kind of clock starts....maybe.

I'm honestly not really understanding what is keeping the 10 year down. Overseas economic conditions (China for example, low European rates) is the only thing I can think of.

I rebalance anyway which is a reactive, not predictive way of investing. I don't try to get ahead of any predictions.

 

[copyright1997reloaded]

The market peaked strongly the last few times the yield curve flattened, then inverted. Then, all hell broke loose a bit more than 1 year later.

I think much has been talked about this, including on this forum. Somehow, people do not believe in this.

You would think everyone would be selling, but perhaps people are hanging on for a few percent more.

I did a bold on some of your quote, which I think is of major importance. Yes, yield inversions usually portend bad things. In my stock market saying bucket, this is the "All Bull Markets End Badly" saying. But, does that mean we should be selling NOW?

First, the yield inversion hasn't happened (yet), and there have been cases were it flattens for a while and then resumes a normal upward slope. For example, at the end of 1994 / early 1995, the 10 year - 2 year spread dipped to 0.09 on 12/27/1994, and then by mid 1995 was back in the 0.50 range. (Note that this was a pretty good time to stay invested in the market). Second, historically after the inversion there is a period of time before the stock market peaks, and that time can be highly variable. Typically that time is 18-24 months, but sometimes it can be earlier or even a quick downturn (perhaps like we saw at the tail end of 2018) where market participants anticipate a recession that fails to show up (at least for a while).

Where I disagree is on the hanging on for a few percent more part. Looking at the past 5 recessions, from first inversion to the market peak the average gain was 22%. That is quite a bit to give up!

So what to do? Either stick with asset allocations and ignore all else, or if one is to try to (dirty word) market time, keep riding the bull while recognizing that yes, indeed, eventually things will end badly. (In other words, take some off the table along the way.)

 

[audreyh1]

Exactly. Flattening means little and can reverse. Inversion counts, but then timing gets tricky.

 

[Lsbcal]

Inversions are not a cause, they’re the result of declining or expected declines in business activity. Bond investors see a decline ahead and extend durations, which pressures longer term yields down while the Fed hikes short term rates.

To be a meaningful signal, the inversion needs to continue for some period of time and be confirmed by other economic indicators. It looks like we are heading into a economic slowdown over the summer.

I had not really put myself in the bond investors position. That is a good point (red above).

It seems that the recent Fed hikes were done in the context of a more healthy domestic and international economic climate then we have at the present. Hence the Fed pause. I recall reading in Greenspan's book that the Fed could see ahead of the markets by only a month or two out given their better information sources.

I agree that just the yield curve flattening and inversion is not enough in itself to crater the market. That is clear from the past data.

 

[audreyh1]

Interesting that the economic indicators from ECRI show that we are pulling out of the recent economic drop, so things might look more robust this summer.

Look at US weekly leading index. It did dip negative, but has been reversing that dip. https://www.businesscycle.com/ecri-reports-indexes/all-indexes

 

[Lsbcal]

Exactly. Flattening means little and can reverse. Inversion counts, but then timing gets tricky.

It is old history but the yield curve flattened in 1957 before the recession in that year. I only have end of month data for this period and that shows no inversion. The 10 year minus 3 month Treasury was under 10 bp about 6 months before the SP500 declined.

I think flattening is a meaningful warning signal but by my definition (somewhat arbitrary) we have not even gotten there yet ... but getting close. I should mention I don't like horror films.

 

[Lsbcal]

Interesting that the economic indicators from ECRI show that we are pulling out of the recent economic drop, so things might look more robust this summer.

Look at US weekly leading index. It did dip negative, but has been reversing that dip. https://www.businesscycle.com/ecri-reports-indexes/all-indexes

Here is a nice Leading Index from the Fed: https://fred.stlouisfed.org/series/USSLIND

The 10 year - 3 month Treasury curve is used as part of this index. Currently the index is benign:

 

[Totoro]

Having real earnings yield below inflation is another danger sign. Since inflation is not that high, we're still ok-ish in that department even with low earnings yields (<3%).

They tend to coincide with flattening yield curves.

 

[brewer12345]

I need to rebalance some $$$ from equities into bonds. Choices are bond funds, cd's from brokerage or treasuries. Money not needed for 8 years or more but I can't decide on how long to go out. Doesn't seem to be any advantages going long?

If this is a typical rebalancing type portfolio, I would stick to high grade instruments (IG corporates, treasuries, agencies and CDs) and probably look for durations between 4 to 7 years. You want this part of the portfolio to hold up or appreciate if equities drop so that you can rebalance at an opportune time. I often hold a mix of funds (easily traded to rebalance) and individual bonds/CDs (not as easily traded, most likely held to maturity). I like the iShares target maturity funds, as I am not fond of negative convexity in my bond allocation. Just bought some IBDO to extend duration from some very short stuff.

 

[audreyh1]

Here is a nice Leading Index from the Fed: https://fred.stlouisfed.org/series/USSLIND

The 10 year - 3 month Treasury curve is used as part of this index. Currently the index is benign:

Yes, I’m familiar with the Fed leading index. I thought you might find the ECRI site interesting.

 

[Lsbcal]

Audrey, it is just that I did not quite know how to interpret the numbers shown on that ECRI link. Without a chart to show context it only shows direction (which is good) but I cannot see how useful it has been in the past. I imagine since they are selling the full data set they think it has had a good track record.

 

[audreyh1]

Audrey, it is just that I did not quite know how to interpret the numbers shown on that ECRI link. Without a chart to show context it only shows direction (which is good) but I cannot see how useful it has been in the past. I imagine since they are selling the full data set they think it has had a good track record.

They generally have a pretty good track record of predicting economic downturns at about 6 months ahead, but you rarely know if it’s going to be a slowdown or an outright recession.

Unfortunately their editorial verbiage sometimes doesn’t match their published data. When this happens I tend to ignore their editorializing. But it’s still interesting.

You can always download the free spreadsheet and see what their data looks like compared to GDP or whatever.

You have to follow them for a while.

But I think it’s just as useful as what the Fed and the NBER publish.

 

[copyright1997reloaded]

If this is a typical rebalancing type portfolio, I would stick to high grade instruments (IG corporates, treasuries, agencies and CDs) and probably look for durations between 4 to 7 years. You want this part of the portfolio to hold up or appreciate if equities drop so that you can rebalance at an opportune time. I often hold a mix of funds (easily traded to rebalance) and individual bonds/CDs (not as easily traded, most likely held to maturity). I like the iShares target maturity funds, as I am not fond of negative convexity in my bond allocation. Just bought some IBDO to extend duration from some very short stuff.

Brewer, I always appreciate your knowledge of debt instruments. One of the things I've done (for better or worse) over the last five years is to substantially reduce my non CD, non-inflation adjusted fixed instrument holdings...simply because rates had become so low I just couldn't make myself own a lot of long term fixed paying 'low' amounts.

Just curious here: What would you think your average duration is at this point?

 

[SecondCor521]

The market peaked strongly the last few times the yield curve flattened, then inverted. Then, all hell broke loose a bit more than 1 year later.

I think much has been talked about this, including on this forum. Somehow, people do not believe in this.

You would think everyone would be selling, but perhaps people are hanging on for a few percent more.

I have heard, probably from CNBC when the yield curve was under discussion in November or so, that:

1. The yield curve flattening does not always result in a market pullback.

2. Even when the yield curve flattens and the market pulls back, the pull back is 12 to 18 months after the flattening happens.

3. During that 12 to 18 month delay, the market typically goes up another 10-20%.

And some of us are just lazy LTBH index types who have set-it-and-forget-it AAs.

ETA: Looks like copyright1997reloaded said essentially the same thing already.

 

[NW-Bound]

With the Efficient-Market Hypothesis, one would think that people would be selling in droves some months after the yield curve inversion.

Perhaps, they did. But I did not.

 

[OldShooter]

With the Efficient-Market Hypothesis, one would think that people would be selling in droves some months after the yield curve inversion. ...

Or that the market consensus is that this is no big deal.

I am not aware of any statistically significant financial results that support the thesis that technical analysis is effective. This includes yield curves, CAPE gyrations, plus head-and-shoulders, resistance levels, support levels, and all the other technician arcana.

Different subject: I am surprised that with all the agonizing over long bonds no one has mentioned TIPS. These basically take all the risk out of the equation and yield a little bit of real interest to boot. They really have no yield curve except in the rear view mirror.

 

[NW-Bound]

I would say that talks about the yield curve, unemployment, interest rate, inflation, trade imbalance, etc... are more fundamental than technical.

When people talk about the dot-com mania, the housing and mortgage mania, and recently the bitcoin mania, they also talk fundamental, not technical.

PS. If one truly believes in EMH, he will get some bitcoins as they are just another "asset" to diversify into.

 

[copyright1997reloaded]

Or that the market consensus is that this is no big deal.

I am not aware of any statistically significant financial results that support the thesis that technical analysis is effective. This includes yield curves, CAPE gyrations, plus head-and-shoulders, resistance levels, support levels, and all the other technician arcana.

Different subject: I am surprised that with all the agonizing over long bonds no one has mentioned TIPS. These basically take all the risk out of the equation and yield a little bit of real interest to boot. They really have no yield curve except in the rear view mirror.

I just mentioned (in passing) TIPS in my post/question to Brewer. Essentially all of my fixed allocation is either in relatively short term savings/CD's or in TIPS. I did this for the reasons you mention, but who knows if this is the best long term approach. I just can't see myself doing long-term corporate bonds when the 30-year AAA rate is around 3.84%.

 

[brewer12345]

Brewer, I always appreciate your knowledge of debt instruments. One of the things I've done (for better or worse) over the last five years is to substantially reduce my non CD, non-inflation adjusted fixed instrument holdings...simply because rates had become so low I just couldn't make myself own a lot of long term fixed paying 'low' amounts.

Just curious here: What would you think your average duration is at this point?

In my 401k where I have few choices, it is whatever the bond index is. Since the index has mortgage paper, whatever number is quoted is a guess. Outside of that, I would say I am pretty short, with nothing over 5 years. A lot is in cds with small surrender penalties. The stuff in bonds is about half in floaters and tips, the rest in fixed rate corporates that have a duration of probably 3 on average.

 

[Freedom56]

My take on interest rates moving forward into 2019 and 2020....

The yield curve will continue to invert with the 10 year note and 30 year bond likely to test the low yields set a few years ago. The only action that will stop this inversion, in my opinion, is when the Federal Reserve starts to cut interest rates again in response to the slowing economy. Much of the growth that we have seen is due to tax cuts and increasing consumer and corporate debt which now stand at record levels. Both corporations and consumers will have to deleverage over the next few years or face the prospect of default.

I have been liquidating my preferred and baby bond portion of my portfolio and raising cash as many of them that I purchased in late December that are up 17% which is more than two years of coupon payments. I am willing to bet that program trading that triggered the sell-off late last year will re-trigger later this year. It makes more sense for me to take gains of the table and float the cash in a money market fund yielding 2.38% and wait patiently as I did last year. The maximum duration of my corporate bonds are 12 years with the average around 6.4 years. I plan to hold those to maturity or early call unless there are some material changes to the company that would cause me to sell prior to maturity.

Those who hold CDs, Treasuries, and quality corporate bonds will do fine. By "quality corporate bonds", I mean those corporations that have sufficient operating earnings to cover their interest payments. Don't go by bond ratings alone. There are many investment grade rated bonds such as GE and Bed Bath and Beyond that should be rated as low grade junk as their fundamentals are deteriorating quickly.

 

[OldShooter]

... If one truly believes in EMH, he will get some bitcoins as they are just another "asset" to diversify into.

I don't think even Eugene Fama would argue that the EMH applies to moonbeams or other intangible assets. The operative belief for bitcoin trading appears to be the greater fool theory.

 

[NW-Bound]

I don't think so either.

I will add that I do think that EMH has validity, but in the soft sense.

I still reserve the right to question the "wisdom" of the masses, in order to dissent when the world has gone mad. Of course it is not easy, but if we say something is impossible then we will never try.