The Market Lately/Bond Vigilantes
In September/October there was nowhere to hide except in the short-term T-bill or currency markets. The S&P was down 4.7% in September. Bonds fell about 2.5%. Small Cap and Tech fell in line with the S&P. Rising interest rates hit income stocks like REITs and utilities even more. Everyone is back in November. Note, September is historically the worst performing month for the stock market and November is the best. The fourth quarter is historically strong, especially starting in November. However what we saw in September was not sustainable. Long-term bond yields rose almost daily with the coincident decline in all of the above equities (falling bond prices). Shown below is a chart of the Long Bond ETF (NASDAQ:TLT) 45% decline From the Extreme (aka the Bond vigilantes are back!). China, Brazil, Saudi Arabia and Japan have stopped buying US bonds and have been net sellers. Link Japan, China reduced US Treasury holdings as currencies hit new lows. There are a lot of new releases. The Fed’s sharp comments also have an impact. A significant rise in long-term bond yields acts like an anchor for stocks.
2-Year Chart of the 20-Year US Bond ETF: TLT
There is talk of increasing bond supply. US GDP is up about 3% so far this year. Pretty solid isn’t it? Well, unless you count the deficit, which will be between $1.8T to $2T by year’s end, or 7 to 8% of US GDP. So let’s take the mid-point of 7.5% and subtract that 3% gain to find that the US economy is actually shrinking by 4.5%, not including the extremely unnatural and inflated government deficit.
What is the right bet and defense in these circumstances? It appears the Fed is at or near the end of its rate hike program and inflation is tapering off – hence the recent rally. This means we are also closer to a new mechanism for lowering rates when something breaks in the economy.
History shows that when the central bank moves by reducing quantitative tightening or stopping interest rate increases and reversing course, the economy is going to go through a difficult period. In fact, the Fed usually arrives late and the downturn has already begun.
Regardless, as famed bond guru Jeffrey Gundlach recently said, “Rates take the stairs up, but the elevators go down.” The following chart is a 2-year to 10-year spread showing yield curve inversion.
We have previously shown how yield curve inversion (blue line below 0) predicts recession (shaded vertical lines).
But notice how quickly and severely the yield spread widens to correct for inversion just before, during, or after a recession. This is mostly a result of the 2-year bond rally (fall in yields) as a result of the Fed funds rate reduction.
Beware of plateaus!
Now let’s look at the history of the fed funds rate since 1955 in the chart below and how the Fed cuts in the face of a faltering economy:
Here we see stairs at the top and elevator at the bottom. The plateaus (circles) are also notable in this chart. Notice what happens after the short flat top periods: recessions (vertical shaded areas) and rapid declines in rates. We are at the end of this tightening cycle and a new plateau is forming. These short periods average 6 or 7 months but can last up to a year (as in 06/07).
Compare this to the following 2-year Treasury yield chart (since 1975):
Circulated Area: Is yield beginning to peak? looks like it.
The following is a 5-year Treasury bond yield chart (since 1955):
It is easy to see rates falling to a lower percentage than the fed funds rate in the cyclical areas of the 1980s and 2000s, but even so, they fall as investors look for high quality havens (buy Treasuries). In the circular area on the right, rates have clearly moved above the trend across all rate horizons.
10-year bond yield chart (since 1955):
The cyclical sector, the 10-year yield is at a low of .55% in July 2020. Note the smooth slope on the long bond chart. Longer rates occur with shorter rates but are less severe.
Conclusion – This is always the case
This takes us back to the title of the update. As the chart above shows, a decline in the fed funds rate has always led to a concurrent decline in other parts of the yield curve (i.e. long-term Treasuries). Unexpected economic shocks typically cause the fed funds rate to fall faster than it rises. Recessions are generally deflationary, leading to lower rate pressures. The Fed always lowers the fed funds rate, or at least it always has, in a recession. Even Fed Chairman Paul Volcker, known for curbing inflation in the 70s, cut rates from 18% in April, 1980 to 9.5% over the next 3 months in view of that year’s mini-recession. done.
It seems prudent to add a medium term period at this point. This can be accomplished by purchasing some form of income/dividend-oriented equities or high-quality corporate or government bonds. If the economy is in the late stages of the cycle, it also seems like a good idea to lighten the equities most dependent on economic growth. What will 6-month to 1-year Treasuries, which currently yield 5.4%, yield in one year? Less, most likely. Probably very little.
We’ll leave you with a final thought from renowned professor and investment guru Benjamin Graham regarding prioritizing quality over income: “It is a principle of investing that securities should be purchased because the buyer believes in their soundness, not because That he needs a fixed income.”