Déjà Vu: Revisiting the Inverted Yield Curve

The sky is falling! The sky is falling! Or is it? The Fed made the unexpected decision last week to leave rates unchanged for the remainder of 2019, a far cry from the very hawkish Fed that predicted multiple rate hikes for this year in December of 2018. This resulted in sharp market movements, with the broader market outside of Financials considering this a tailwind for the stock market. After all, when there is more cash available, where does it go? If you’re searching for yield, the answer has been stocks for many years now.

Then, last Friday on March 22, the stock market moved sharply lower after the already-flattening yield curve inverted as the 3-month Treasury yield fell below the 2-year. And this, ladies and gentlemen, is where we find ourselves today: another yield curve inversion, last experienced in December of 2018.

What is a yield curve inversion
On March 22, 2019, last Friday, yield curves inverted when the 3-month Treasury yield fell below the 2-year yield. For quick understanding, the yield moves inverse to the price of a bond. When yields fall, that means the prices have risen with higher demand. Investors typically want a better return if their money is locked up for a longer time. When the yield curve is inverted, however, this means that the shorter investment now has a higher return (the interest rate is higher even though the longer-dated Treasury should carry more interest rate risk).

This can be interpreted in different ways, but typically (although not necessarily) this yield situation means bad events may be ahead. The last time this occurred was with the 5-year and 2-and-3-year treasuries back on December 3, 2018. At that time, markets sold off viciously on recession fears. This time, market reaction has been more subdued, but the S&P 500 still fell 1.90% by the close on March 22.

Recently, the broader market (S&P 500) has been supported on an upwards trajectory on relatively solid earnings data and optimism around a US-China trade deal. Most investors seem to expect some sort of a trade deal with certain enforcement mechanisms to be reached. Meanwhile, outside the United States, economic data has been less promising, with Beijing and then the ECB announcing stimulus measures to deal with potential economic slowdowns. Additionally, in the United States, nonfarm payrolls severely disappointed expectations by nearly 8x, with only 20,000 jobs created in February.

Global economic conditions, coupled with the recent inversion of the yield curve, does warrant some attention and wariness when it comes to equities, but this doesn’t mean the bull run is over by any means. The Fed could lighten up on interest rates, perhaps lower rates by a bit, and the situation would change. Regardless, a considerable amount of money remains on the sidelines since the December declines, and investor may become more comfortable with lower earnings growth (note, earnings are still growing, just not as at fast a rate) going forward. This doesn’t change The Ignorant Investor’s mantra, however. Quality is the name of the game- quality, a compelling story, and a pristine balance sheet. Quality companies that are in the game for the long run don’t need to be concerned by the daily fluctuations of the market; these are the types of investments that allow investors to sleep deeply and securely at night.

Energy Markets
Oil prices have recovered well since the beginning of the year, now up more than 30% at yesterday’s close. This price movement is well-supported by relatively stable demand and OPEC+ production cuts.  Additionally, sanctions on Venezuela and their continued decline in oil production capabilities have also helped support prices. On the flip side of this, US oil production has risen sharply and exports have continued to rise as the US begins to take market share from OPEC.

Consolidated Audit Trail: Improved market transparency and accountability leads to greater credibility
Let’s take a walk through recent history. Back in 2010, something occurred on May 6 that caused major indexes in the US stock markets to drop nearly 10% within minutes, only to recover all of the losses by the end of the week. Some fortunate traders made hundreds of thousands of dollars, if not millions, within a ten-minute window. Other unlucky traders missed out when the regulator arbitrarily decided to invalidate some trades (based on the percentage gained from the artificial drop). Some called foul. Many market participants were confused and perplexed. What happened? Everyone was guessing. Finally, in 2015, the US charged a single trader from London with manipulating markets and unknowingly causing that flash crash. Good for them- but notice the time stamp. The entire process took FIVE YEARS to complete.

This was a big problem. Regulators couldn’t immediately piece together the positions around the time of the crash and it took years to process all the data. Going forward, this was not a good situation. As a result, the Consolidated Audit Trail was formed to create greater transparency for US equity markets. This repository will track orders in real time and maintain a database of positions in the US stock market- a very powerful tool for regulators to examine market activity and irregularities going forward. After many delays, the buildout of this tool is nearly complete and slated to be ready for operation sometime next year.

The Wall Street Journal reported that the SEC decided to eliminate some personally identifiable information from the Consolidated Audit Trail repository in the name of cybersecurity; all in all, some very good news. Once open for business, this tool will also be the veritable Fort Knox of stock market information, containing positions of all market participants at any given point in time. Read about it here.