The Great Inversion yields at last
The last time the 1 year UST yield was below the 10 year yield was July 11, 2022. The curve inverted on July 12, and it hasn’t looked back since. Until today.
As I discussed in Is The Yield Curve Obsolete?, it’s a bit of an oversimplification to say the yield curve is or is not inverted. It’s a complex curve, and you can only make binary statements about it by choosing two points for comparison. Most financial media choose the two and ten year yields, but sizable contingent prefers the 3 month and 10 year yields. Others can be examined, but Financology splits the difference by focusing on the 1 & 10.
Today Treasury reported the one and ten year yields both at 4.28%. Within a rounding error, ignoring the variations at other maturity points, that’s dead flat. Having come from negative territory, it seems likely a positive relationship isn’t far off.
We’ve discussed the significance of inversion and uninversion at length in these pages. In brief, inversion has been a widely regarded omen of recession. But “recession” itself isn’t well defined (current orthodoxy is whenever NBER says there has been one, arguably more political or bureaucratic than economic, especially considering two quarters or negative GDP growth in 2022 weren’t called a recession); and as investors the market implications are our main focus anyway. If the length and depth of the inversion is any indication, they could be long and deep.
The gist of it is that although inversion gets the most press, it’s the uninversion following a period of inversion that’s the timely indicator. From inversion it might be 6-24 months or longer before the supposed event. Uninversion by our lights would be near coincident, at most six months tops, even factoring in the lag between a recession beginning and when it’s recognized. In other words, if the projected denouement isn’t evident within a few months, we can finally say the yield curve indicator didn’t work.
Until then, declarations of the death of the yield curve, based on the failure to recognize the significance of uninversion, will have been premature.
It is almost certain that for every yield curve inversion there will be a subsequent uninversion. [I would guess that the exception would be in a sudden hyperinflation.] This means that all one need to do avoid being invested in a recession and taking a double digit percentage drawdown is to start raising cash when the yield curve inverts; waiting for the uninversion just allows one to stay invested a bit longer.
If it really is as simple as that, I’m going to bang my head against a wall. 🙂
Haha … if only! Like snowflakes, every cycle is different.
The last one was in 2019. The yield curve both inverted and uninverted that year. Precedent forshadowed a recession (in market terms, a bear market) in early 2020. And we got one all right, but other events, shall we say, rather eclipsed all memory of the yield curve action.
The yield curve inverted in January 2006. Aside from a couple brief resurfacings, it remained underwater until August 2007. Stocks topped out in October, then lost over half their value over the next eighteen months. Again, the entire bear market transpired after the curve had uninverted.
Before that, it inverted in March 2000. This time, the beginning of the bear market coincided with inversion. But most of the declines nevertheless fell after the uninversion at the very end of that year. Stocks didn’t bottom until October 2002.
In each case, taking the uninversion as a sign the inversion omen had passed would have been financially catastrophic.
Of course this is only a small sample of three (the last three) full cycles. And again, reducing the totality of the yield curve to a binary variable based on just two points omits a lot of data. The current as yet incomplete cycle featured a bear market in 2022 that actually began before the curve inverted, but which ended while it remained so. It remains to be seen what happens after uninversion.
The gist of it this time is that the lengthy period since the yield curve first inverted has prompted numerous declarations of the demise of the yield curve indicator. History says we have a little ways to go before any such thing can be confirmed.
I’m not making a market forecast, but think an extra measure of caution is in order at until we’re well clear of the whole cycle. There are reasons to suspect that precedent could be nullified this time around … especially that short rate policy doesn’t work the way it used to. For most of its history, the Fed supported its target rate by making reserves scarce … banks would bid rates up to obtain them. Now it holds them up by paying interest on excess reserves, putting money into the system to hold rates up. Quite different things – higher short rates are easier money than they used to be – but whether it’s a yield curve game changer, we won’t have to wait much longer to find out.
Today the YC is officially positive, the ten year yield exceeding the one year by a whole basis point … 4.29% to 4.28% … breaking the tie cited above.
In other news, gold is at an all time high of $2789.65 as I type.
Relentless.
Early results are consistent with the ongoing validity of the yield curve omen as I’ve set forth. Stocks topped out on October 14 and have since sold off. The yield curve uninverted October 28.
This should be regarded however as highly preliminary. While it is possible a bear market in stocks began this month and that the uninversion heralds it, we’re also entering a seasonally bullish period for stocks. If the negative implications of the uninversion survive the seasonal tide through year end, I would take that as confirmation of the yield curve omen’s ongoing validity.
Gold experienced a mini-crash today (cue Mega “Gold getting killed!”). The only real surprise to us was that it rose as far as it did first. As I remarked just a few days ago, it was due for a rest. Whether today was enough or there is more to come is too short term a question to be much more than a crap shoot.
The longer term picture remains as solid as ever. The foundation for this year’s run was laid by the Fed when it caved to its Wall Street masters and started teasing rate cuts prematurely last December. Our Market Outlook 2024 commented to that effect, and being as I eat my own cooking I went overweight in my own portfolio at the time, profiting together with Financology readers. Our diversification in the broader commodity space served us well even today as oil prices surged.
Now the Fed has actually cut rates and is widely expected to repeat the mistake in a few more days, meaning it very likely will, having so enslaved itself to market expectations. Sure, there are other variables involved – war, rumors of war, election jitters – but the enduring fact is that the Treasury is up to its eyeballs in debt and the Fed will come under pressure to monetize it. Not good policy, since it was too low too long rates that enticed the government up to its eyeballs in the first place, but good policy hasn’t been at the top of its priority list for almost thirty years. The dollar’s weakness will be gold’s strength.
The news late this week is that Warren Buffett has been selling a bunch of equities lately (he most recently sold over $20B of Apple stock) and Berkshire Hathaway is now sitting on a whopping $325B of cash that is kept in Treasury bills.
Buffett evidently sees the 4.61% – 4.75% as a better place to put Berkshire Hathaway’s capital than the equity of the “wonderful businesses” they are still invested in but to a much smaller degree.
I don’t know how good of a timer Buffett is and my recollection is that his record is mixed. He most certainly avoided the insanity of the dot-com bubble but he totally screwed up on the housing bubble and would have taken heavily losses if it weren’t for a massive Federal Reserve bailout.
Buffett seems to not see obvious frauds as he had a problem with Salomon Brothers in the early 1990s and there was self-dealing with one of this executives (David Sokol) more recently. In that regard, Buffetthas his own kind of “irrational exuberance” blind spot but it’s with dishonest management rather than obviously overpriced businesses (with the exception being airlines).
I see Buffett’s current actions as one driven by excessive valuations. In my readings of his investing history, Buffett has never been an investor who is too cautious. He seems to finally be acting more urgently on the elevated levels of the “Buffett Yardstick” of equity valuations versus GDP.
Thanks for bringing that up Milton. Buffett has indeed been lightening up on stocks, notably with BofA, Apple, and others. And it is almost certainly valuation related. I doubt he sees any particular event coming, just a poor risk return trade off.
He would hardly be alone. Vanguard among others sees low ten year returns. Lance Roberts from RIA cites more:
Lower Forward Returns Are A High Probability Event
Buffett’s weakness though is that however good a stock picker he may be, it’s as if he only considers paper assets like stocks and cash. He disdains gold, which has actually trounced stocks so far this century, not to mention cash. Even Buffett could do better by expanding his two dimensional universe to commodities. A two legged stool isn’t the sturdiest foundation … the third pillar of commodities is needed for a complete portfolio.
Looking beyond the US could help too. There are probably some attractive opportunities in smaller US names too, but they might not be practical for a portfolio the size of Buffett’s.
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