An inverted yield curve is usually scary. Not this time.

  • By Randall W. Forsyth,
  • Barron's
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The tab for tariffs continues to rise, with the Dow Jones Industrial Average (.DJI) shedding another 3% in its sixth straight losing week, which was highlighted by President Donald Trump’s new threat to impose tariffs on Mexico to deter asylum-seeking migrants from crossing the U.S. border.

Even before this latest salvo in the trade war, the cost to U.S. stock investors has been $5 trillion, according to the calculations of Deutsche Bank strategist Binky Chadha. That’s the U.S. equity returns he figures were forgone in the past 17 months of the trade war. During that span, the S&P 500 index (.SPX) has been basically stuck in a range, which was a break from its 12.5% annual price appreciation since the bull market began in 2009. Those $5 trillion in gains that didn’t materialize equals 12 years of the bilateral merchandise trade deficit with China, Chadha points out.

While Trump famously views the stock market as the report card for his presidency, he’s not gaining much now politically from the tariffs, according to an analysis by Goldman Sachs’ economics team. Trump’s poll numbers aren’t even getting a boost in the key swing states of Iowa, Ohio, Michigan, Pennsylvania, and Ohio, they find. And while tariffs on Chinese goods are generally more popular than other trade levies, the president’s approval ratings actually tend to improve when trade tensions subside.

But even if the escalation in trade disputes takes a toll on the financial markets and the U.S. economy in the short term, Goldman thinks it would have only a modest impact on next year’s presidential election. What really counts is how the economy, the labor market, and stocks are doing around the second quarter of 2020. So, the bank concludes, Trump might want to wait until later this year to nail down a deal with China for maximum effect.

The new threatened tariffs on goods from Mexico could be a further drag on the economy. While the tariffs will hike some prices, they ultimately are a deflationary tax on consumers, who have to cut back on other stuff. That impact raised the odds of Federal Reserve interest-rate reductions, with at least two cuts of one-quarter percentage point being priced in by the futures market.

Signs of economic worry sent bond yields plunging globally, with the 10-year Treasury yield sliding to 2.139%, the lowest since September 2017 and down more than a full percentage point since its recent high last October. JPMorgan economists think such easing moves to offset the tariff drag would “make abysmal growth attainable” (MAGA, in case you didn’t get it).

To one who has been unnaturally obsessed with the yield curve for more years than I care to admit, the sudden attention garnered by this once-obscure indicator is surprising. But when it lands on page one of the New York Times, attention must be paid.

The Treasury yield curve’s so-called inversion—with the benchmark 10-year note’s yield (2.15%) trading below that of the three-month bill (2.35%)—has spooked the stock market because this flip from the typical configuration historically has been a portent of recession. Indeed, every recession has been preceded by a negatively sloped yield curve. And as longer-term Treasury yields have declined steadily in recent weeks, the disquieting question of “what does the bond market know” has rattled the stock market, leaving the Dow Jones Industrial Average lower for the sixth straight week.

So, it is with no small measure of trepidation that I write what historically have been the four most dangerous words in the chronicles of financial markets: It’s different this time.

That refrain previously was heard repeatedly in the middle of the past decade, when the Treasury yield curve was nearly ruler-flat after the Fed moved up its federal-funds rate target in glacial fashion. Alan Greenspan, then Fed chairman, called the lack of a rise in longer-term yields a “conundrum.” His successor, Ben Bernanke, would continue to raise short-term rates to fight a transitory uptick in inflation, even as the yield curve signaled that price pressures were waning.

Robert Kessler, head of the eponymous firm that manages Treasury portfolios, predicted in a Current Yield column I wrote in September 2006 that the resulting deflationary pressure on housing would force “the Fed to come to the rescue of the financial system” by slashing rates the following year. Bernanke, for his part, would contend in 2007 that the subprime problem was “contained,” a year before the great financial crisis and the collapse of Lehman Brothers.

Notwithstanding the risk of not giving the history of yield-curve warnings their due, when the signals from the real economy are positive and diverge from the dour ones sent by the bond market, it’s typically bullish—not bearish—for the stock market.

That’s what Jim Paulsen, chief investment strategist at the Leuthold Group, found. Indeed, the bigger the divergence between the upbeat signals from private-sector measures and the downbeat ones in the bond market, the more bullish the outlook for the stock market for the next six months. High consumer confidence and a strong labor market run counter to the yield’s curve’s warning.

To be sure, other astute observers warn against thinking that the yield curve is saying something different this time. Among them is Harley Bassman, who created the MOVE Index, the bond market’s analog of the Cboe Volatility Index, or VIX (.VIX), for stocks, when he headed Merrill Lynch’s mortgage trading in the 1990s. Now retired and penning the Convexity Maven occasional commentary, his latest missive dismisses that “the best and brightest are bleating now ‘it’s different this time.’ ”

Why would “well-heeled investment professionals” effectively buy five-year bonds to be issued in 2024 at yields below the current, risk-free overnight interest rate? Bassman can’t pinpoint the source of a surprise that this variety of an inverted yield curve implies. Still, he’s battening down for some macroeconomic or political disturbance.

Academics, as well, are quick to deride the notion that the yield curve’s signal is different this time, with a paper in the June issue in the NBB Review comparing it to Cassandra’s unheeded warnings of the fall of Troy. After reviewing the history of yield-curve inversions, the authors note that the yield curve’s impact on the economy has decreased since the mid-1980s, after the Volcker Fed killed the previous double-digit inflation. With credible inflation targeting by central banks, bond markets could assume that an uptick in short rates to fight inflation would be short-lived and that long-term yields would remain stable or decline.

The extraordinary monetary measures used since the financial crisis further affected the yield curve as a leading indicator. The so-called term premium—the extra yield that investors demand to hold longer-term bonds—has fallen to an all-time low, as Alexandra Scaggs of Barron’s wrote on Thursday. The relative shortage of safe long-term assets and the increased global demand for them, combined with the large stock of Treasury and agency mortgage-backed securities siphoned off the private market by the Fed, may be depressing the term premium and tilting the yield curve negatively.

But when the real, private economy is signaling optimism at the same time the yield curve is screaming a warning, Paulsen finds that it’s actually a buying opportunity for stocks.

Looking back at the history since 1967, he constructed a model to compare consumer confidence with the 10-year Treasury yield. When this “confidence gap” has been in the highest quartile for the period, the subsequent six-month return from the S&P 500 index averaged 14.34%, with a 20.36% probability of a decline. When the gap between consumer confidence and the change in the Treasury yield has been in the lowest quartile, the S&P return has averaged less than half as much, 6.76%, with a much higher chance of a decline, some 38.06%. Paulson’s model now is 93% higher than all other six-month time frames since 1967, which suggests stronger returns ahead.

All of which is a statistical analysis that suggests a corollary to Warren Buffett’s aphorism to be greedy when others are fearful and fearful when others are greedy. When bond traders on Wall Street are spooked, and consumers on Main Street are confident, Paulsen’s work says to heed the latter. Consumer confidence basically has remained on a high plateau for most of the past two years, reflecting in no small part the strong labor market, as indicated by the historically low level of new claims for unemployment insurance, down at 215,000 in the latest reading. (It’s interesting to note that both the yield curve and jobless claims are components of Conference Board’s Leading Economic Index.)

Bassman, for his part, likes investments that he says have taken a beating from the yield-curve flattening. These include leveraged closed-end funds that invest in mortgage-backed securities and other credit-sensitive assets, municipal bonds, master limited partnerships, real estate investment trusts that invest in mortgage securities, and business-development corporations. Many muni CEFs trade at 10% discounts to their net asset values, he notes. If the Fed lowers rates, as the yield curve implies, these leveraged investments should see dividend increases. If he’s wrong on that score, Bassman says he can lick his wounds while collecting 9% yields (mid-4% range for tax-free muni CEF yields).

The fed-funds futures market on Friday placed two-to-one odds on a cut as early as September, according to the CME FedWatch site, up from about even money a week earlier. A Fed easing would probably lift risk assets, but to take advantage means having cash on hand to pounce on those opportunities. At least short-term investments pay more to wait than bonds.

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