It passed with little fanfare, but the spread between the 2-year and 5-year Treasury notes went negative yesterday, the first inversion of the yield curve since 2007. Why wasn't this the top headline in the financial media? Because the 2-year/5-year spread is much less widely followed than the 2-year/10-year spread. The 10-year U.S. Treasury note is the most liquid of the Treasuries and one of the most liquid securities in all of global markets and thus it the true benchmark for interest rate traders. The 5-year Treasury lies in what is known as the "belly" of the yield curve and attracts far fewer investor dollars than the 10-year.
So, breathe a sigh of relief if you will, but the 2/10 spread is currently a minuscule 13 basis points, and thus the margin for error for an upward-sloping yield curve is basically nonexistent.
Why does this matter? Well, a quick glance at Bloomberg's excellent 2/5-year chart shows that a yield curve inversion from early 2000 to the beginning of 2001 set the stage for the tech bubble bursting, and a much longer period of inversion from the beginning of 2006 until mid-2007 was, in retrospect, a perfect predictor of the Crash of 2008-2009.
By definition an inverted yield curve is contractionary for the economy owing to the balance sheet structure of banks. A basic rule of deposit-taking institutions it to “lend long” and “borrow short.” When you deposit money at your bank you are funding that bank’s activity but retain the right to pull that money out whenever you choose. Hence your balance is listed as a “demand deposit” and classified as a liability on your bank’s balance sheet. If that bank’s loan officer can lock in long-term loan at higher rate than the short-term cost of funds the bank has locked in a profit margin on those funds.
Yes, as many bullish pundits have noted, there is generally a lag of at least one year between a true yield curve inversion and a U.S. recession. Recessions are called by an organization known as the National Bureau of Economic Research, which is completely ignored by the Street and relevant only to economic geeks like myself for their after-the-fact declarations of the duration of recessions.
If you own stocks you should be looking through the windshield not the rear window, though, and thus you should be more interested in the predictive value of flat and inverted yield curves than the minutiae of economic data collection.
The recent flattening of the yield curve has been caused by a normal expansion of yields on Treasuries in the 3-month to 2-year range, the expected impact from the series of six Fed Rate hikes that we have had since December 2015. I pointed out in this Forbes article that the recent Fed tightening has encompassed the same number of rate hikes in the same time period as those that preceded the Tech Crash in 2000-2001. This is not mere numerology, it is an absolute waiting to lighten up on equity exposure here.
The real problem is that long-term yields stubbornly refuse to rise, or "back up" in bond trader parlance. Observers, especially the bullish ones, will throw out a million different reasons why this happening, but they almost always miss the big one: the Fed.
According to its website the New York Fed owned a staggering $2.1 trillion of Treasury notes as of last Wednesday in its System Open Market Account (SOMA). Treasuries compose the largest portion of the NY Fed’s $3.9 trillion holding of long-term securities, which also includes $1.7 trillion in agency mortgage-backed securities. The SOMA account balance is below its peak levels of about $4.5 trillion as the Fed has stopped using new money to buy Treasuries. That said, as shown in this statement, the Fed continues to use rollover process of maturing bonds over a certain threshold of proceeds ($30 billion for Treasuries and $20 billion for MBS) to re-invest in other Treasury note series. The Fed has curtailed its buying but has not yet sold a single dollar’s worth of the SOMA holdings it acquired in its quantitative easing (QE, QE2, etc.) operations.
So, there are more than $2 trillion of U.S. Treasury notes that are not circulating and are held by an entity that has a policy of not selling them. That's a huge externality in the market and is a major factor keeping long-term interest rates lower, as the Fed has a bias toward holding longer-dated bonds.
The Fed is artificially suppressing long term interest rates at the same time that short-term interest rates are being raised by, yes, you guessed it, The Fed.
So, that's the conundrum facing Jerome Powell and the Federal Open Market Committee. The market is pricing in rate hike at the next FOMC meeting on Dec. 18th-19th--the CME’s FedWatch tool shows an 83.5% chance for that outcome in this morning’s trading. With only 13 basis points separating the 2-10 year Treasuries today, though, such a rate increase would, other things equal, throw the yield curve into inversion.
Will Powell and co. risk a yield curve inversion? I think the FOMC has painted itself into a corner, and has to raise in mid-December. Powell’s dovish speech at the New York Economic Club ignited last week's stock market rally, but if he and his colleagues don’t throw the market one more rate hike participants will wonder if the FOMC knows something about the economy that they don't.
At the end of the day, I don't want to own stocks in that environment. What is intellectually tidy about all this this is that the very force that has pressured the stock market since its highs in September--the rising yield on the 2-year Treasury note--now offers--with a 2.83% yield--a clear alternative to the paltry 1.9% yield offered by the S&P 500.
So, don't fight the tape and don't ever fight the Fed. Lighten up on stocks and increase your short-term bond holdings here. It's an easy to way to protect your portfolio.
