Learn Liberty VIDEO of the Week: "Gold vs. The Full Faith & Credit of the U.S. Government"

This #LearnLibertyClassic takes a look what it means for money be backed by gold instead of the more abstract "full faith and credit of the U.S. government."
Posted by Learn Liberty on Friday, January 15, 2016

The "Inverted Yield Curve": A Perfect Track Record Predicting U.S. Recessions...

A Perfect Track Record For Forecasting U.S. Recessions 

There are very few market indicators that can predict recessions without sending out false positives. 

The Yield Curve is one of them. 

Recently, LPL Financial's Jeffrey Kleintop noted that the yield curve inverted just prior to every U.S. recession in the past 50 years. 

"That is 7 out of 7 times — a perfect forecasting track record," he reiterated. 

The yield curve is INVERTED when short-term interest rates (e.g. the 3-year Treasury) are HIGHER than long-term interest rates (e.g. the 10-year Treasury yield). 

"The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about 5 to 16 months," wrote Kleintop in a recent note.

"The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits." 

The Federal Reserve has been signaling that tighter monetary policy is on its way, which means short-term interest rates should move higher. Is this something we should be worried about? Kleintop offered some context:

"How far the Fed must push up short-term rates before the yield curve inverts by 0.5% depends on where long-term rates are. Even if long-term rates stay at the very low yield of 2.6% seen in mid-June 2014, to invert the yield curve by 0.5% the Fed would need to hike short-term rates from around zero to more than 3%. Based on the latest survey of current Fed members that vote on rate hikes, they do not expect to raise rates above 3% until sometime in 2017, at the earliest..."

Lots of economic and market factors drive what happens with interest rates. So the shape of the yield curve is definitely worth paying attention to. 

"The facts suggest the best indicator for the start of a bear market may still be a long way from signaling a cause for concern," he said.

Are We Headed for A Prolonged Japanese Deflationary Slog?

If you look at the progression of the U.S. stock market boom and bust, it's easy to see comparisons to the long deflationary slog experienced by Japan.

What's more, we have a similar monetary structure (our own currency, with mostly domestically-owned, domestically denominated debt), and we're facing a similar crisis (too much private sector debt).

The Treasury market shows it as well.

The spread between current Treasury yields and yields on Japanese Government Bonds has hit a new multi-decade low.

And beyond that, the progression of the Treasury yield collapse has has gone at a similar pace.

This chart comes from Nomura's Richard Koo, lining up 10-year yields between Japan and the U.S. at the start of each respective crisis.

Bottom Line:

10-year Treasury yields have a lot longer to fall if you think Japan is a good guide. 

1st Quarter 2011 Stats: S&P 500, Small Caps, Foreign Stocks, T-Notes

The S&P 500 gained +5.9% in the 1st quarter of 2011.  For all of calendar year 2010, the S&P 500 gained +15.1%.  The S&P 500 has gained an average of +9.7% per year (total return) over the last 50 calendar years (i.e., 1961-2010) (source: BTN Research).    

As of its end of the 1st quarter closing value (1326), the S&P 500 is still -18% below its all-time closing high of 1565 set on 10/09/07. (source: BTN Research).     

The international stock index EAFE gained +3.4% YTD (total return) through 03/31/11 and is up +10.4% on a trailing 1-year basis as of the end of the first quarter this year.  The EAFE stock index has bested the S&P 500 on a total return basis in 7 of the previous 10 calendar years.  The EAFE is an unmanaged index that is generally considered representative of the international stock market (source: BTN Research). 

The small-cap Russell 2000 is up +7.9% YTD (total return) through 03/31/11 and is up +25.8% on a trailing 1-year basis as of that date.  The Russell 2000 index is an unmanaged index of small-cap securities which generally involve greater risks (source: BTN Research).     

The yield on the 10-year Treasury note was 3.46% on 03/31/11.  The yield on the 10-year Treasury note was 8.05% on 03/31/91 or 20 years ago (source: Treasury Department). 

High-Yield Bonds & The Historical Impact of Rising Interest Rates...

Even at historical low yields of about 7%, high-yield corporate debt stacks up favorably against the S&P 500, which has a dividend yield of less than 2%. That means stocks, which are a lot more volatile than bonds, would need to gain at least +5 percentage points of performance just to keep up with a more predictable 7% yield from high-yield bonds.

Historically, high-yield bonds have not been as sensitive to interest rate increases as investment-grade bonds and treasury bonds.

For example, one of the biggest threats to fixed income right now is that a sudden spike in interest rates — currently at historic low levels — would further wipe out returns. According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility.

Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between +117 and +222 basis points.

The average total return of high-yield bonds for those same 12-month periods was +5.5%, with just one negative-return period.

In comparison, the average total return for investment-grade corporate bonds over the same periods was a loss of -0.1% ,  including three negative-return periods.

Of the six 12-month periods, the worst performance for high-yield bonds was a decline of -1.57% in 1994, when the Treasury yield climbed by +204 basis points. Over the same period, investment-grade bonds fell by -3.34%.

The best 12-month period for high yield was through May 2004 when the bond category gained +13.23% on a 130-basis-point gain in the Treasury yield. Investment-grade bonds over the same period fell by -0.47%.

One of the main reasons high-yield bonds are able to weather interest rate volatility is the yield “cushion,” according to Sabur Moini, manager of the $1 billion Payden High Income Fund (PYHRX). For example, the current 6.8% average yield on high-yield bonds compares with a 3.8% average yield on investment-grade bonds.

“The bigger yield cushion makes high-yield bonds a lot less interest-rate-sensitive,” Mr. Moini said.

“Typically, low growth, but not in a recession, is the best environment for high-yield bonds,” said Michael Collins, co-manager of the $700 million Prudential Total Return Bond Fund (PDBAX). A little bit of inflation and projected economic growth in the +2% to +2.5% range “is almost the sweet spot for high yield,” he said.

High-Yield Bonds Hit Record...

Junk bonds closed out a record-setting August and look poised to resume their bull run in September, despite—and because of—persistently weak returns and outlooks for other asset classes.

August saw $23.0 billion in high-yield bond issuance, according to data provider Dealogic, the 7th-largest monthly volume on record. The performance was remarkable because August has historically been a relatively quiet month, and because no junk bonds priced during August's final 10 days.

After holding firm in July and early August, corporate bonds faded late in the month, losing some value in thin secondary market trade. A market respite is normal during peak late-summer vacation season, but this one also coincided with the worst August for equity markets since 2001.

Junk bonds, which often move in tandem with stocks, now are tasked with regaining their momentum in September—historically the worst month of the year for equities—and October, the second worst.

Despite how far junk bonds have come—returning +57% in 2009 and +8.3% in 2010 to date, according to Merrill Lynch—investors still see the potential for further gains.

"Considering the continued improvement in corporate balance sheets and how much demand there's been for high yield, there's still a lot of value in the high yield market," said Gibson Smith, fixed-income portfolio manager at Janus Capital Group.

Fund managers such as Mr. Smith cite current average high-yield risk premiums of +6.9 percentage points above Treasurys, more than a full percentage point higher than historical norms, and say that could shrink further without getting out of line with default expectations, even while underlying Treasury rates bounce along near historic lows.

The economy keeps struggling, but fixed-income market participants point out that their asset class is less reliant on growth than equities in order to produce solid returns.

"The last several weeks there's been a lot of press given to the weak economic data and slowing growth numbers, and that's led to a downturn in equities," said Jim Merli, head of debt distribution and origination at Nomura Securities. "We're of the view that we are going to see relatively modest growth at a level which will be positive for the credit markets."

Why Market Risk May Be Higher Than You Think: Reason #2 of 5...

2. The Fed is nervous.

In August the Fed warned that the economy had weakened, and it unveiled its latest weapon in the war against deflation: using the proceeds from the sale of mortgages to buy Treasury bonds. That should drive down long-term interest rates. Great news for mortgage borrowers. But hardly something one wants to hear when the Dow Jones Industrial Average is already north of 10000.

The High-Yield Bond / Treasury Bond Ratio: A Barometer of Economic Health

Charts courtesy of www.StockCharts.com

When the RED line trades ABOVE the BLUE line, we are BULLISH on High-Yield Bonds and the U.S. economy.

• We SELL Treasury Bonds and BUY High-Yield Bonds.
  

When the RED line trades BELOW the BLUE  line, we are BEARISH on High-Yield Bonds and the U.S. economy, and we are BULLISH on Treasury Bonds.

• We BUY Treasury Bonds and SELL High-Yield Bonds.

Note that The High-Yield Bond / Treasury Bond Ratio forewarned of an economic contraction in the summer of 2007, ahead of the worst recession since the Great Depression of the 1930s (the RED line traded BELOW the BLUE line). 

And it didn't turn up until the coast was clear for the U.S. economy and the U.S. stock market in the late spring of 2009.