Dan Shainberg
December 5, 2018
While our newsletter has been calling for a recession and market decline for months now, and we finally got a big one, today's newsletter will instead focus on what the pundits are not talking about. It's easy to point to the popular news de jour and try to make a correlation. China, the Fed or a large tech company's fiscal report sound like they could be reasons for the equity markets to react. But when you see 700-800 basis points of index erosion in a single day, I would argue that you are better off analyzing the bond markets to induce an explanation, not CNN or CNBC.
When looking at the bond markets, we see a nuanced yet meaningful change. The "yield curve" is one of the most followed graphs that credit investors track. It charts the yields offered from government bonds of varying maturities. Traditionally, the yield curve displays an upward sloping pattern as inflation expectations warrant higher returns for fixed income investors willing to part with their capital for a longer time. But when the yield curve inverts, or flips to a pattern where shorter term bonds offer higher yields than its longer term counterparts, that is an uncommon pattern and a signal for concern in the macro-economy and equity markets.
"Jeffrey Gundlach, CEO of DoubleLine Capital, says the U.S. Treasury yield curve inversion on short end maturities are signaling that the economy is poised to weaken.”
The inversion occurs because investors bid up the prices of longer term bonds as they anticipate risk in the economy and markets. Traditionally bonds are less volatile than equities, so if you are a pension fund manager, and expect significant volatility in the coming years, you will shift your allocation to bonds. This increased demand causes the price to rise and commensurate yield to shrink. The short end however remains elevated or may even experience higher yields because those investors concerned about the future don't want to hide in the bond markets for a few months or years. What would happen when those short term bonds mature? If their bearish inclinations are correct, they would have to reallocate maturing debt proceeds into lower yielding bonds or declining equities. So they prefer to lock into long term debt driving up its price. However, if the Fed hikes short term rates, like they are now, to tighten the monetary supply and reign in inflationary risks, then the short term bond market will see rising rates. The combination of rising short term rates and declining long term rates can cause the yield curve to invert. Right now, the yield curve has flattened out and is starting to invert. It is a classic signal that the bond market, often referred to as the "smart money," is signalling to investors that the current expansion phase of the economy is nearing its end and may soon turn into a recession.
It's impossible to accurately explain short term movements in the equity markets. But if one had to guess, I'd choose the bond market's yield curve inversion as the main culprit for yesterday's sharp equity market selloff over China or Trump or the Fed.
December 5, 2018
While our newsletter has been calling for a recession and market decline for months now, and we finally got a big one, today's newsletter will instead focus on what the pundits are not talking about. It's easy to point to the popular news de jour and try to make a correlation. China, the Fed or a large tech company's fiscal report sound like they could be reasons for the equity markets to react. But when you see 700-800 basis points of index erosion in a single day, I would argue that you are better off analyzing the bond markets to induce an explanation, not CNN or CNBC.
When looking at the bond markets, we see a nuanced yet meaningful change. The "yield curve" is one of the most followed graphs that credit investors track. It charts the yields offered from government bonds of varying maturities. Traditionally, the yield curve displays an upward sloping pattern as inflation expectations warrant higher returns for fixed income investors willing to part with their capital for a longer time. But when the yield curve inverts, or flips to a pattern where shorter term bonds offer higher yields than its longer term counterparts, that is an uncommon pattern and a signal for concern in the macro-economy and equity markets.
"Jeffrey Gundlach, CEO of DoubleLine Capital, says the U.S. Treasury yield curve inversion on short end maturities are signaling that the economy is poised to weaken.”
The inversion occurs because investors bid up the prices of longer term bonds as they anticipate risk in the economy and markets. Traditionally bonds are less volatile than equities, so if you are a pension fund manager, and expect significant volatility in the coming years, you will shift your allocation to bonds. This increased demand causes the price to rise and commensurate yield to shrink. The short end however remains elevated or may even experience higher yields because those investors concerned about the future don't want to hide in the bond markets for a few months or years. What would happen when those short term bonds mature? If their bearish inclinations are correct, they would have to reallocate maturing debt proceeds into lower yielding bonds or declining equities. So they prefer to lock into long term debt driving up its price. However, if the Fed hikes short term rates, like they are now, to tighten the monetary supply and reign in inflationary risks, then the short term bond market will see rising rates. The combination of rising short term rates and declining long term rates can cause the yield curve to invert. Right now, the yield curve has flattened out and is starting to invert. It is a classic signal that the bond market, often referred to as the "smart money," is signalling to investors that the current expansion phase of the economy is nearing its end and may soon turn into a recession.
It's impossible to accurately explain short term movements in the equity markets. But if one had to guess, I'd choose the bond market's yield curve inversion as the main culprit for yesterday's sharp equity market selloff over China or Trump or the Fed.
Dan Shainberg
#DanShainberg
#RecessionResister
@DanShainberg
@DanShainberg
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