Bond Yields And Recessions

Question from a former colleague: "you're a bond guy, where's that inverted yield curve?". This is from someone who thinks the S&P 500 will hit 3500 before the next recession (that is a 25% move higher from where we are today), so we shall call him / her a stock bull.  Financial markets are far from an exact science, so some can extrapolate more positive signals from the current economic and investing environment. That is what makes markets: those with a more positive outlook are the buyers, those with a less positive outlook are the sellers. On any given day, more buyers than sellers will drive prices higher (and vice versa), that is what makes markets work. 

We can debate value (in stocks) all day, but...

First, lets look at the chart above: the recent history of the 2 (gold), 10 (green) and 30 (purple) year US bond yields. When there is a widening between those lines, the yield curve is normal (positive sloping). However, when the US Federal Reserve embarks on a tightening of monetary policy (raising interest rates), the 2 year yield rises at a significantly faster pace than the 10 or 30 year yield. We "bond guys" call this a flattening of the yield curve (red arrow). When 2 year yields rise above the 10 and 30 year yields, it is referred to as an "inversion". Historically, this flattening of the yield curve is followed by a recession (but it does not necessarily have to invert), usually because the US Fed raises rates at a pace that is too fast for the economy to handle (some refer to that as a "policy mistake"). It appears that historically, the Fed has made a bunch of these "policy mistakes". Odds are that it is not going to be any different this time. As I like to put a probability on events occurring (nothing is ever certain), lets say its between 60-70% that we are staring a recession in the face. In which case, I (and we at High Rock) should conduct my/our investing strategy accordingly. Stocks don't historically do well in recessions.

Has the most recent tightening been too much for the economy to handle? US personal income and spending in December were dramatically lower and put lots of slowing pressure on the US economy. Remember, the US consumer is about 2/3 of the economy. Q4 GDP slowed to a 2.4% annualized pace (from 3.3% in Q3). The early call for Q1 2019 is for something below 1.5% annualized growth. The Fed has "paused" the tightening process. Is it too late? Perhaps. The rest of the global economy has also been stalling and that is not helping. The impact of a US-China trade deal is too far away to be of significant consequence in the near-term.

Closer to home, the Bank of Canada started "putting the brakes" on the Canadian economy back in the summer of 2017 (raising interest rates and flattening the Canadian yield curve). Last quarter, the Canadian economy barely grew at all. Economic forecasting can be tough. However, it would appear that the downside risks to the economy grew to be bigger than the BOC anticipated. Interest rates are too high and impacting highly indebted households (not the first time I have brought this to my readers collective attention): So...

1) Household spending slows and the housing market softens

2) Non-residential business investment continues to fall

3)Export and import volumes edge down

If you want to be bullish on stocks heading into this environment, knock yourself out (those in my camp are happy to have buyers to sell to). I / we (at High Rock) are not so positive (and remain purposefully cautious and prudent with our and our clients hard earned savings).