Another market truth biting the dust ? Either that, or we're in for a bumpy ride .......

Tuesday 27th June 2017

Another market truth biting the dust ? Either that, or we're in for a bumpy ride .......

ref :- "Shift in distress gauge puts US investors on edge" , The Financial Times, Analysis - Capital Markets

Yesterday it was the Phillips Curve under fire, and suggestions that changing work practices are undermining the direct link between employment and inflation. Today it's the turn of flattening yield curves, what they've always meant in the past and why the accepted wisdom on the subject may also be passing into the category marked "Long-established market truths that may not be so true any more". Then again, it may very well turn out that the accepted wisdom remains as reliable as ever ..... which at one level might come as a relief to old lags in the market-place confused by a changing world, but will be of no comfort to investors whatsoever.

Intuitively, it makes perfect sense that borrowing for the long-term should cost more than doing so for a short period ..... or if you prefer, that long-term bond yields are higher than those of short-term equivalents. Thus the "yield curve", derived from a simple graph with the level of yield along one axis and the length of maturity of a bond along the other, can be expected to be represented by a healthy upward-sloping line. That very simple line or "curve"  would illustrate that yields are higher the longer the maturity of the bond.

And most of the time, all things being equal, that is the case ..... but not ALL of the time. Yield curves do flatten (and can even invert), and when they do it's been a pretty reliable indicator that a recession is on the way, predicting almost every downturn in the US since WW2. So the fact that the curve is flattening now in pretty dramatic fashion has made some investors extremely nervous.

The spread between the two- and thirty-year Treasury yields is 137 basis points (1.37%) , its narrowest for 10 years and down from over 200bp at the end of last year when over-excited expectations of the Trump reflation trades held sway. The 2yr / 10 yr Treasury yield spread is at 80bp, only just above the 9 year low of 75bp established last summer.

It's not hard to see why the yield-curve is flattening. The policy-sensitive 2yr yield is reacting to Fed hikes in interest rates, whilst longer bond yields have fallen as growth and inflation expectations have fallen. Short yields higher + long yields lower  = curve flattening. But these falling yields at the long end of the bond market, just as with the curve-flattening itself, testify to a deepening pessimism about the economic future. How do we reconcile that with an ebullient stock market that is anything but pessimistic ?

The short answer is that we can't ...... something's got to give, surely ? Bank of America analysts calculate that if the Treasury bond market had the same view on growth prospects as the stock market, then yields would have to rise 50-65bp ...... or alternatively, if stocks were suddenly to fall in line with the bond market view of things, then stocks would be between 13 and 20% lower. BoA believe that a sell-off in bonds (which means a jump in yields) is the more likely outcome, but whatever the case there are good reasons for everyone to be nervous.

But the optimists have a different take on it. They argue that falling long-term Treasury yields are the result of global capital inflows and have nothing to do with reflecting the prospects for the US economy. China has resumed buying of US Treasuries, and then we have to take those that Jim Leaviss of M&G Investments calls "yield refugees" into consideration. With the European Central Bank and the Bank of Japan continuing to sit on yields through their bond-purchasing QE programmes, investors from those areas desperate to find some yield (any yield ?) from top-rated AAA securities are finding what's on offer in US Treasuries still more attractive than the negligible returns they can get at home.

Mr Leaviss suggests that rather than fret over what a flattening of the yield-curve usually signals, the Fed might actually like the way things are panning out. We spoke yesterday about the Taper Tantrum that followed the first move by Fed Chair Ben Bernanke to tighten monetary policy by reining back the QE programme. Havoc in the market-place and soaring bond yields ensued, which amongst other things sent mortgage costs sharply higher and threatened the housing recovery. It was a chastening experience for the Fed and not one they'd wish to repeat. Now, in contrast, the Fed is able to normalize (raise) rates at the short end without disturbing long-term yields and the mortgage rates that are tied to them.

Inflows are definitely playing their part, but it's hard to argue that the biggest factor behind falling long-term yields (and therefore curve flattening) is anything other than falling inflation  .... and falling expectations of inflation in the future, as measured by "break-even" rates. You'll remember that these are derived from the difference in yields between conventional bonds and their inflation-protected equivalents (TIPS), and they've also been tumbling all year. Of course we know rising inflation is bad for bond markets (lower prices,  higher yields) as it eats into FIXED returns. Naturally enough, falling inflation has precisely the opposite effect ..... and that's where we're at now.

Subdued inflation data at a time of very high employment means that it's possible to make a case for judging the Phillips Curve theory to be outdated . But what about the market mantra that flattening yield curves presage economic downturns ? Do the new realities about inflation and the effects that inflation has on bond yields mean that this widely accepted market warning sign become redundant too ? Time will tell and it may indeed pan out that way, but the curve has a pretty good record in this respect and we can't help feeling that wise investors would consider it foolish not to take note.