OMG !! The Yield Curve Just Inverted ! Sell or Not Sell ?
This is probably one of the hottest topics where you can see and read from all over the business news headlines in the last two weeks.
What is “ Inverted Yield Curve “ and why is it so important that draw so much attention from financial strategist/economist/investors/fund managers all over the world. Discussing, pondering and arguing about the impact and direction of the economy due to this so-called “ Inverted Yield Curve”, relentlessly.
Inverted Yield Curve <From Investopedia.com>
What is an Inverted Yield Curve?
An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.
A partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than 30-year Treasuries. An inverted yield curve is sometimes referred to as a negative yield curve.
Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006, and again in 2007before U.S. equity markets collapsed. The curve also inverted in late 2018. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are demanded, sending the yields down.
Yields are normally higher on fixed-income securities with longer maturity dates. Higher yields on longer-term securities are a result of maturity risk premium because changes in the value of longer-term securities are more unpredictable with market interest rates potentially more unsettled over a longer time horizon. However, yields on longer-term securities could be trending down when market interest rates are set to get lower for a foreseeable future to accommodate on-going weak economic activities. Irrespective of their reinvestment rate risk, shorter-term securities appear to offer higher returns than longer-term securities during such times.
Yield and the Economy
The shape of the yield curve changes in accordance with the state of the economy. The normal or up-sloped the yield curve may persist when the economy is growing and conversely, the inverted or down-sloped yield curve is likely to press on when the economy is in a recession. One underlying reason such a relationship exists between the yield curve and economic performance relates to how a higher or lower level of long-term capital investments may help stimulate or rein in the economy. By issuing longer-term securities with lower-yield offerings, businesses and governments alike can acquire needed investment capital at affordable costs to jump-start a weak economy.
Yield and Bond Demand
What moves yields in the market is the varying demands for securities of different maturities at a particular time and under given economic conditions. When the economy is heading to a recession, knowing interest rates are to trend lower, investors are more willing to invest in longer-term securities immediately to lock in current higher yields. This, in turn, increases the demand for longer-term securities, boosting their prices and further lowering their yields. Meanwhile, few investors want to invest in shorter-term securities when presented with lower reinvestment rates. With lower demand for shorter-term securities, their yields actually go up, giving rise to an inverted yield curve when yields on longer-term securities have come down at the same time.
Why is an “ Inverted Yield Curve “ so important that causing so much volatility to the market …. Yes !! , “an inverted yield curve has actually predicted the past seven recessions.”
A Fully Inverted Yield Curve, And Consequently A Recession, Are Coming To Your Doorstep Soon < From SeekingAlpha.com>
|image credit to Bloomberg.com|
Inverted Curves Not Only Signal Recession. They Might Cause One < From Bloomberg.com>
“That’s because banks tend to make money from short-term borrowing at lower rates which they lend at higher rates for longer periods of time. An inverted yield curve can make that business much less attractive.
“Bank profits get squeezed when short-term interest rates rise relative to the yields on long-term assets. This can lead banks to cut back on their lending, which, in turn, can put the brakes on economic activity,”
Well, the inverted yield curve doesn’t mean that you have to sell all your stocks and goes for 100% in cash of your portfolio, immediately. It’s not like “war or bank-run” type of crisis that market plunge immediately after the news. It is just that the probability of “ recession” getting higher base on past trend on similar yield curve pattern.
You may want to hear different point of view as below ….before pressing the sell button.
Does the Yield Curve Really Forecast Recession? < From FED of St Louis>
Why an inverted yield curve doesn’t mean investors should immediately sell stocks < From Marketwatch.com>
“Even if the YC (yield curve) inverts tomorrow, over the past seven economic cycles, the median SPX gain from the initial inversion to the cycle peak is 21%, with a recession a median 19 months after the initial inversion,” said Dwyer.
The strategist also stressed that other recession identifiers, including the Fed’s Senior Loan Officer Survey, household debt service and financial obligation ratios, and consumer delinquency rates, have yet to set off alarms.
As such, investors should wait for further signs of trouble in the credit market before turning defensive on stocks.
<Quoted from CNBC.com>
“Janet Yellen, former chair of the Federal Reserve, said Monday that the recent triggering of a recession indicator in the U.S. bond markets could signal the need for a rate cut and not a prolonged economic downturn.
"In contrast to times past, there's a tendency now for the yield curve to be very flat," she said, adding that it's now easier for it to invert — which traditionally meant investors had become concerned about a future downturn.
"And in fact, it might signal that the Fed would at some point need to cut rates, but it certainly doesn't signal that this is a set of developments that would necessarily cause a recession," Yellen added.”
This time is different ( 4 most dangerous words in the Investment world !!)
From the above comments by former FED Chair (Janet Yellen ) if is true, there might be a secular change in the long term yield curve which is very flat and easier for it to get inverted.
Look at the below chart where central bank from world major economies still sitting with more than USD 20+ Trillions of asset in their balance sheet, as a result of “ The Mother of All Q.E “ after GFC in 2008/09. Also, with hundreds of billions of cash pile from corporations which been used to carry out share buyback to historically high hence push up the stock’s valuation.
|image credit to Bloomberg.com|
From Treasury’s record, foreign entities/countries continue to put their monies into US long term Bond. Treasury securities ( Long Term ) held by foreign residents/ entities increased by USD 1,124 Billion from Jan- 2012 to Jan-2019 (USD 90 Billion increased from Jan 2018- Jan 2019). At the same time, FED started the QT ( Quantitative Tightening ) from 2015 by deleveraging of their balance sheet by selling the short term treasuries bill. In Mar-2019 vs Mar 2018, FED short term treasury bill ( less than 10 years ) reduced by USD-232 Billion as compared to long term ( 10 years or more ) decreased by only USD-9 billions.
The QT from FED also came from reducing the MBS ( Mortgage-Backed Securities ), which have closed to USD 1.76 Trillion sitting in their balance sheet during the peak in 2017 and reduced to USD 1.5 Trillion in Mar 2019.
The unintended consequences of selling short-term (T-Bill ) from FED and buying long term ( Bond ) by foreign entities/ countries might have accelerated the inversion of the yield curve, of course, the main culprit still, be the increasing of FED rate since 2016.
What Am I Going To Do With My Portfolio?
The Yield Curve Just Inverted, Putting The Chance Of A Recession At 30% < From Forbes.com>
“The interest rate on the U.S. Treasury 10-year bond just fell below the rate on the 3-month bill in response to the Fed's March announcement. This is called yield curve inversion as defined by Arturo Estrella and Frederic Mishkin (Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER) . It implies a 25%-30% probability of a recession on a 12-month view. Their research can be found here.”
Base on the above research paper from NBER, there is still a 30% of chance that an inverted yield curve may lead to a recession but I am not going to do an immediate major change to my portfolio just because of the yield just inverted. Also, this is not “war-type” of crisis that one may see the market plunge immediately right after the news breakout. We will still have 2-6 quarters to react and adjust our portfolio as the market may continue to move upward for a while.
One should analyse and interpret the situation in conjunction with other macro indicators (e.g. Unemployment/consumer consumption & confident, wages, corporate earning, retail sales etc ), we shall see how the economy moving forward and things develop in the next few quarters. Recession may happen not because of "inverted yield curve" but changing of sentiments and behavioural among of economic agents...which may lead to multipliers effect on decelerating of "animal spirits ".
It might be too extreme to go for 100% cash at this moment but since I am more than 80% vested (exclude CPF balance ) and depending on my dividends to cover my monthly expenses, I will just increase my war-chest for next few quarters from whatever dividend I received. The most important is still having a diversify & good fundamental stocks in your portfolio and with some war-chest ready.
How about you? what is your reaction to this so-called “inverted yield curve” event?
Quote Of The Day :
“More money has been lost because of four words than at the point of a gun. Those words are 'This time is different.” by Carmen M. Reinhart.