Personal Finance: Bond market flashing yellow on economy

Personal Finance: Bond market flashing yellow on economy

An interesting dichotomy has developed between the stock and bond markets over the past few weeks. Stock prices in the United States have reclaimed all-time highs, suggesting confidence in continued economic growth and corporate profits. Meanwhile, bond investors are singing from a different sheet of music, as their trading activity belies a high probability of impending recession. Those conflicting signals present a dilemma for investors seeking to rebalance portfolios going forward. Over time, the bond market is usually right, but not always. So, let’s take a look at why bonds are sounding the tocsin.

One significant predictor of future recession prospects is the behavior of longer-term interest rates compared with short-term yields. The graphical relationship is known as the “yield curve,” a plot of effective rates for U.S. Treasury bonds of various maturities. Normally, investors would demand a higher interest rate for later-dated bonds since their money will be tied up longer. The benchmark indicator of the yield curve is the difference between the 10-year Treasury bond and the three-month T-bill. For example, in January 2017, the difference or “spread” between 10-year and 3-month instruments was a full 2 percentage points, represented by an upward-sloping (normal) yield curve.

However, from time to time, the normal relationship breaks down and the yield curve “inverts” or slopes downward. This means that the effective return on 10-year bonds is actually lower than the three-month bill, a reasonably powerful predictor of economic slowdown or recession sometime over the following 12 to 18 months.

It is not infallible: the yield curve has inverted several times in the postwar period without a recession following, but virtually every recession has been preceded by an inversion (think 2001 and 2007). Research from the New York Fed indicates at least a 30% probability of a recession in 2020 at the current spread.

The reason longer-term rates can slip below short-term rates is simple: bond investors have grown pessimistic regarding future growth compared with the present. Considering that the current expansion is now 10 years old, such an expectation is hardly incomprehensible.

Investors (and most financial pundits) habitually overstate the importance of Federal Reserve policy over the intermediate term. For example, following its extraordinary policy responses to the Great Recession, the Fed has sought to normalize the benchmark interest rate under its control, called the Fed Funds rate, at which banks lend excess cash reserves to each other. Since December 2015, the Fed has hiked the Fed Funds rate 10 different times totaling 2½ percentage points (250 basis points).

However, the yield on the 10-year Treasury bond has actually declined since then from 2.2% to a recent low below the 2% threshold. This is a reminder that ultimately, the market calls the tune and often provides a powerful signal of future activity.

These developments are particularly significant, given the already low absolute level of interest rates that leave policymakers very little ammunition with which to combat a slowdown. And the dilemma is even greater abroad: not only has the yield curve in Europe frequently inverted, but investors in the Eurozone are actually willing to accept negative interest rates on government bonds.

Let that sink in: buy a $1,000 German government security, and get back $950 in five years. It is estimated that more than $13 trillion in negative-yielding bonds are currently outstanding, hardly a sign of optimism.

An inverted yield curve should not be taken in isolation, but on top of a destructive trade policy, increasing global tensions, and lofty stock valuations, investors would be well-served by reviewing their asset allocations to prepare for any rough weather ahead.

Christopher A. Hopkins, CFA

Vice President and Portfolio Manager
Barnett & Company

Chris Hopkins

Chris Hopkins, CFA, is Vice President and Portfolio Manager for Barnett & Company. He is a native of Whittier, California and has lived in Chattanooga since 1988. He began his career in finance in 1998, following twenty years in manufacturing management. Chris joined Barnett & Company in 2004. He served for twelve years an adjunct professor of Finance at UTC, and writes a weekly column for the Chattanooga Times Free Press on finance and economics. He is currently president of the CFA Society of East Tennessee, and is a member of the North Carolina and South Carolina CFA Societies as well as the National Association for Business Economics. He presently serves as city council representative on the Chattanooga fire and police pension board, and is member of the finance committee for the AIM Center. Chris holds the Chartered Financial Analyst (CFA) professional designation. He received Bachelor’s degrees in Physics and Economics from California State University at Fullerton, and earned his MBA from the University of Tennessee at Chattanooga.
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