Beware the Yield Curve

This post Beware the Yield Curve appeared first on Daily Reckoning.

If you’re a regular Daily Reckoning reader, you’ve probably heard of the “yield curve,” and an “inverted yield curve.” A yield curve inversion is a classic recession warning signal. This is a very powerful indicator because it has preceded every recession of the last 60 years.

That means an inverted yield curve has preceded recession on seven out of seven occasions for the past 60 years. Only once did it give a false positive, and that was in the mid-1960s.

And when recessions hit, stocks are vulnerable to crashes. An inverted yield curve has provided warning of every major stock market “event” of the past 40 years.

That’s why several different measurements of the yield curve are important to monitor. The most-cited yield curve calculation is the 10-year U.S. Treasury yield minus the 2-year U.S. Treasury yield.

But a market crash is not an immediate reaction to a yield curve inversion. During the last two major bear markets, for example, the worst of the selling didn’t start until a few years after the yield curve hit zero or negative. So when you hear that the yield curve has inverted, it doesn’t mean you have to run out and sell all your stocks. It can be a very long time before it shows up in the stock market.

But you should watch the Fed. During these bear markets, the selling of stocks coincided with a panicked series of rate cuts from the Fed.

If investors become risk averse and fear an imminent recession, Fed rate cuts cannot stop investors from selling stocks and de-risking their portfolios. It’s important to realize that Fed interest rate policy can only exert control over the stock market if investors maintain a strong appetite for risk.

The message from a different measure of the yield curve — like the 10-year Treasury yield minus the 3-month Treasury yield — is similar. Incidentally, the Fed places more importance on this part of the bell curve than the 10-year/2-year part of the curve.

The change in this yield curve, shown in the green line below, has been substantial thus far in 2020:

IMG 1

If these two yield curves remain near zero (or below zero) for an extended period of time, then the machinery of bank credit creation can grind to a halt. That’s why anytime the yield curve gets too depressed, the Fed tends to react by cutting short-term rates. Lower short-term rates in turn “re-steepen” the yield curve. In other words, it’s an attempt to restore the normal shape of the yield curve.

It’s no wonder the fed funds futures market has boosted its probability of a 25 basis point Fed rate cut at the June 2020 meeting from about 15% to 37% in just the past few weeks.

Far ahead of this move in the futures market, my colleague Jim Rickards predicted that the Fed would cut rates 25 basis points at the June meeting in an effort to re-steepen the yield curve. If the Fed doesn’t cut rates soon, then the supply of bank loans is likely to tighten in the months ahead.

Having described these trends, we need to ask: How does the yield curve affect the real economy?

During credit booms, banks are happy to make new loans because the interest rate on loans generally exceeds the cost of funding those loans (through deposits and the like). And when banks create those loans on the asset side of their balance sheet, they simultaneously create new money supply on the liability side of their balance sheet.

A growing money supply usually means there’s plenty of money flowing through the economy. As this money flows from consumers to producers, it can be used to service outstanding debts that have been made in the past.

U.S. government deficits and Fed balance sheet expansions also add to the money supply, but most of today’s money supply (the so-called “M2” supply) was loaned into existence by the banking system.

As banks’ “net interest margins” compress, they tend to get pickier about what loans they make. And as loan growth slows, money supply growth slows.

The yield curve foreshadows the trend in future bank profit margins, and it doesn’t look bullish.

If banks aren’t earning decent profit margins on new loans, that’s a problem for a highly indebted economy with many borrowers that must constantly refinance their loans.

Within a matter of months, loan defaults can spike. When defaults get bad enough to threaten the banking system, the Fed panics and cuts rates. We haven’t seen many defaults in recent bank earnings reports, but there are concerning trends in credit card defaults.

This credit cycle has lasted an extraordinarily long time because the Fed kept emergency-style monetary policy in place from 2008 up until it started timidly hiking rates in December 2015.

Super-easy policy has allowed an epic boom in credit — especially in corporate bonds — to hit unprecedented heights. The burden of bank debts and bond debts is as big as ever, so the U.S. economy has become less tolerant of a flat yield curve over time.

Many investors have been waiting to sell stocks and de-risk portfolios until six or 12 months past the point of yield curve inversion. Such investors are confident that we’re in the equivalent of 1999 or 2006 in the cycle, so they expected one last “melt-up.”

The sharp rebound in stocks since December 2018 certainly looks like a melt-up, despite the latest concerns about the coronavirus, which have affected the stock market. But the market’s still at or near record highs, depending on the day.

Maybe the market has more room to run. But most stocks have risen long past the point of being supported by valuations and are dependent on more and more new buyers entering the market to continue rallying.

But with each economic cycle, the heavily indebted U.S. economy clearly has less tolerance for tight monetary policy, yield curve inversion and slowing money supply growth.

Corporate profits have been getting squeezed for several quarters, but investors largely have not cared. They only care that the Fed reversed its policy course rapidly in 2019, switching to radical easing.

Could another 25 basis point cut in mid-2020 rekindle another wave of speculation?

Perhaps. But the next Fed rate cut would likely be in response to deteriorating credit conditions. And stocks rarely rise under such conditions.

So this is the time to be careful.

Regards,

Dan Amoss
for The Daily Reckoning

The post Beware the Yield Curve appeared first on Daily Reckoning.

Beware the Yield Curve

This post Beware the Yield Curve appeared first on Daily Reckoning.

If you’re a regular Daily Reckoning reader, you’ve probably heard of the “yield curve,” and an “inverted yield curve.” A yield curve inversion is a classic recession warning signal. This is a very powerful indicator because it has preceded every recession of the last 60 years.

That means an inverted yield curve has preceded recession on seven out of seven occasions for the past 60 years. Only once did it give a false positive, and that was in the mid-1960s.

And when recessions hit, stocks are vulnerable to crashes. An inverted yield curve has provided warning of every major stock market “event” of the past 40 years.

That’s why several different measurements of the yield curve are important to monitor. The most-cited yield curve calculation is the 10-year U.S. Treasury yield minus the 2-year U.S. Treasury yield.

But a market crash is not an immediate reaction to a yield curve inversion. During the last two major bear markets, for example, the worst of the selling didn’t start until a few years after the yield curve hit zero or negative. So when you hear that the yield curve has inverted, it doesn’t mean you have to run out and sell all your stocks. It can be a very long time before it shows up in the stock market.

But you should watch the Fed. During these bear markets, the selling of stocks coincided with a panicked series of rate cuts from the Fed.

If investors become risk averse and fear an imminent recession, Fed rate cuts cannot stop investors from selling stocks and de-risking their portfolios. It’s important to realize that Fed interest rate policy can only exert control over the stock market if investors maintain a strong appetite for risk.

The message from a different measure of the yield curve — like the 10-year Treasury yield minus the 3-month Treasury yield — is similar. Incidentally, the Fed places more importance on this part of the bell curve than the 10-year/2-year part of the curve.

The change in this yield curve, shown in the green line below, has been substantial thus far in 2020:

IMG 1

If these two yield curves remain near zero (or below zero) for an extended period of time, then the machinery of bank credit creation can grind to a halt. That’s why anytime the yield curve gets too depressed, the Fed tends to react by cutting short-term rates. Lower short-term rates in turn “re-steepen” the yield curve. In other words, it’s an attempt to restore the normal shape of the yield curve.

It’s no wonder the fed funds futures market has boosted its probability of a 25 basis point Fed rate cut at the June 2020 meeting from about 15% to 37% in just the past few weeks.

Far ahead of this move in the futures market, my colleague Jim Rickards predicted that the Fed would cut rates 25 basis points at the June meeting in an effort to re-steepen the yield curve. If the Fed doesn’t cut rates soon, then the supply of bank loans is likely to tighten in the months ahead.

Having described these trends, we need to ask: How does the yield curve affect the real economy?

During credit booms, banks are happy to make new loans because the interest rate on loans generally exceeds the cost of funding those loans (through deposits and the like). And when banks create those loans on the asset side of their balance sheet, they simultaneously create new money supply on the liability side of their balance sheet.

A growing money supply usually means there’s plenty of money flowing through the economy. As this money flows from consumers to producers, it can be used to service outstanding debts that have been made in the past.

U.S. government deficits and Fed balance sheet expansions also add to the money supply, but most of today’s money supply (the so-called “M2” supply) was loaned into existence by the banking system.

As banks’ “net interest margins” compress, they tend to get pickier about what loans they make. And as loan growth slows, money supply growth slows.

The yield curve foreshadows the trend in future bank profit margins, and it doesn’t look bullish.

If banks aren’t earning decent profit margins on new loans, that’s a problem for a highly indebted economy with many borrowers that must constantly refinance their loans.

Within a matter of months, loan defaults can spike. When defaults get bad enough to threaten the banking system, the Fed panics and cuts rates. We haven’t seen many defaults in recent bank earnings reports, but there are concerning trends in credit card defaults.

This credit cycle has lasted an extraordinarily long time because the Fed kept emergency-style monetary policy in place from 2008 up until it started timidly hiking rates in December 2015.

Super-easy policy has allowed an epic boom in credit — especially in corporate bonds — to hit unprecedented heights. The burden of bank debts and bond debts is as big as ever, so the U.S. economy has become less tolerant of a flat yield curve over time.

Many investors have been waiting to sell stocks and de-risk portfolios until six or 12 months past the point of yield curve inversion. Such investors are confident that we’re in the equivalent of 1999 or 2006 in the cycle, so they expected one last “melt-up.”

The sharp rebound in stocks since December 2018 certainly looks like a melt-up, despite the latest concerns about the coronavirus, which have affected the stock market. But the market’s still at or near record highs, depending on the day.

Maybe the market has more room to run. But most stocks have risen long past the point of being supported by valuations and are dependent on more and more new buyers entering the market to continue rallying.

But with each economic cycle, the heavily indebted U.S. economy clearly has less tolerance for tight monetary policy, yield curve inversion and slowing money supply growth.

Corporate profits have been getting squeezed for several quarters, but investors largely have not cared. They only care that the Fed reversed its policy course rapidly in 2019, switching to radical easing.

Could another 25 basis point cut in mid-2020 rekindle another wave of speculation?

Perhaps. But the next Fed rate cut would likely be in response to deteriorating credit conditions. And stocks rarely rise under such conditions.

So this is the time to be careful.

Regards,

Dan Amoss
for The Daily Reckoning

The post Beware the Yield Curve appeared first on Daily Reckoning.

Ed Moya – Senior Market Analyst at OANDA – Tue 28 Jan, 2020

A bounce back in markets today but the treasury market could force the Fed’s hand very soon

Ed Moya kicks off today with a quick comment on the US equity markets and some other factors to watch throughout this week. The Coronoavirus is still causing a lot of volatility but with the Fed statement tomorrow we could have something a bit more long term to consider. Also we discuss the moves in treasuries after the 10 year dipped below 1.6%, but has recovered above that level today.

Click here to visit the OANDA website and follow along with what Ed is writing on a daily basis.

Exclusive Comments from Marc Chandler – Fri 8 Nov, 2019

We recap the key market moves and news from this week

Marc Chandler, Managing Partner at Bannockburn Global ForEx joins me for a comprehensive recap of the market moves this week that continued to push US and international market to higher levels. A lot was on the back of trade optimism which Trump is trying to pullback after his comments today. Pay attention to Marc comments regarding markets not always following fundamentals.

Click here to visit Marc’s blog and keep up to date on a daily basis.

Jordan Roy-Byrne – Technical Commentary on the Metals – Wed 23 Oct, 2019

A steepening yield curve and a Fed pause might not be as bad for gold as you think

Jordan Roy-Byrne joins me for a broad look at the main drivers for gold. Over a year ago Jordan was saying that gold would finally move when the Fed switched course from rate hikes. That happened at the end of last year and helped gold go though a very good 2019 so far. Now it is important to understand what could happen to gold if the Fed stops it’s rate cuts. We cover a lot in the interview but it is all important to understand.

Click here to visit Jordan’s site – The Daily Gold.

Mike Larson – Safe Money Report – Thu 29 Aug, 2019

There are some amazing extremes in the US bond market right now

Mike Larson, Editor of The Safe Money Report joins me to outline some historical extremes that we are seeing in the US bond market. As much as people want to dismiss the importance of the yield curve inversion the wide range of lower yields are telling a very important story about how worried investors are right now.

Also I will be traveling today back east for a wedding tomorrow. Posting will be light for the next couple days however please keep in touch by emailing me at Fleck@kereport.com. If you have any suggestions on companies to meet with at the Beaver Creek Conference please include those in your email and I will be sure to set up meetings.

Click here to follow Mike on Twitter.

Weekend Show – Sat 17 Aug, 2019

Hour 1 – Featuring Axel Merk, Mike Larson, and an update from Auryn Resources
Full Hour

It was another volatile week for US stocks but the real standout was the continued fall in yields and a quick inversion of the 10year/2year yield curve. Recession fears are on the minds of traders which is helping the safe assets garner a buy. We focus a lot on yields in this hour and also get an update from Auryn Resources.

Please keep in touch by emailing me at Fleck@kereport.com.

  • Segment 1 and 2 – Axel Merk, President and CIO of Merk Investments kicks off the show with a comprehensive look at the markets. Take note of what Axel says regarding money flows into risk off assets being more a hedge right now.
  • Segment 3 – Mike Larson, Editor of The Safe Money Report focuses on the falling yields in the US. We discuss what this means for the Fed and why he continues to like defensive stocks.
  • Segment 4 – Ivan Bebek, Executive Chairman of Auryn Resources provides a full update and answers your questions on the status of the properties in Peru. We also discuss the work just completed at Committee Bay and the possibility of an asset.

Exclusive Company Interviews This Week


Axel Merk
Mike Larson
Ivan Bebek – Auryn Resources

Chris Temple from The National Investor – Wed 14 Aug, 2019

Summarizing moves in US markets, the USD, treasuries, and commodities

Chris Temple wraps up today with his thoughts on the weakness today in risk on assets. This continues our ongoing discussions today about weakness in the US and the inversion of the yield curve. Investors are worried and rightfully so.

Click here to visit Chris’s site and take advantage of his special for new and current subscribers.

John Rubino over at Dollar Collapse – Wed 14 Aug, 2019

More Bearish Signs For US Markets

John Rubino, Founder of the Dollar Collapse website shares his thoughts on the falling markets, yield curve situation in the US and how gold is performing through all of this. We also discuss how the gold stocks are lagging and how gold stocks performed when the last recession hit.

Click here to visit John’s site.

Joel Elconin – Benzinga Pre-Market Prep Show – Wed 14 Aug, 2019

There are many reasons to be worried about the health of the US markets

Joel Elconin, Co-Host of the Benzinga Pre-Market Prep Show takes a broad look at the US markets and shares what has him worried. These worries range from weakness in oil stocks, yield curve inversions, and the government now attacking the tech stocks. Even though the markets were at all time highs not too long ago the bearish argument is starting to build up steam.

Click here to visit the Benzing Pre-Market Prep Show website to listen to recordings and live shows.