The conventional wisdom among fixed-income traders is that the bond market is smarter than the stock market when it comes to forecasting where the economy is headed.
Considering that many of the smartest stock traders agree with this notion, it’s always worth keeping a watchful eye on the fixed income markets.
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When it comes to reading the debt markets, one of the most valuable things we can analyze is the shape of the yield curve. Back in 2013, I wrote an article explaining the importance of the yield curve, and what the shape of the yield curve implies for economic growth moving forward.
You can find more detail in the article, but here are the basic takeaways:
An upward sloping yield curve indicates a normal, healthy economy, where investors demand an additional premium (yield) for longer maturity bonds.
A flat yield curve indicates an economy under duress, as investors are not being compensated for the additional risk of longer maturity bonds.
A downward sloping or “inverted” yield curve indicates the economic outlooks is very bleak. It’s a sign that investors are hunkering down for trouble ahead, and stashing their money away in longer-term bonds.
Brexit recently unleashed some powerful forces in the market, and I thought we’d take a look at the shape of the yield curves of the top 5 economies to see what they’re signaling. Based on nominal GDP, those countries are the United States, China, Japan, Germany, and the United Kingdom.
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The charts that we’re about to examine show these yield curves at three different time periods: as they stand currently, one month ago, and one year ago. Understanding how each yield curve has trended over the past year will provide additional context to the current state of debt markets.
To begin here is the shape of the US yield curve. Notice that while our yield curve is still positively sloped, it has been flattening over the past year. This is indicative of a struggling economy and seems to jibe with the latest slew of economic data.
If there are any positives here, it’s that a) none of our interest rates are in negative territory yet, and b) the yield curve has not inverted. The article linked above explains in more detail how reliable inverted yield curves are at predicting economic recessions in the months and years ahead. At this point, the situation looks bleak, but investors aren’t yet in hunker down mode.
Next up is China. China is one of only a handful of economies that still has a respectable interest rate structure, and that’s primarily because their economy is growing at a modest rate (at least according to their numbers). With an annual GDP growth rate of 6.7% and an inflation rate of 2%, China is simultaneously the world’s envy in economic growth, and perhaps the biggest concern over the possibility of an impending slowdown. Notice here, too, that their yield curve is flattening, indicating an increasingly troubled growth outlook.
Moving on to Japan, we now enter the realm of negative interest rates. Below we see what appears to be a very flat, or possibly slightly inverted yield curve from 6-month maturities all the way out to 7 years. We have to look out 20 years just to find 0% yielding bonds, and even at 40 years, Japanese Government bonds are still paying essentially no interest. Once again, notice the flattening that has occurred just over the last year. Are you starting to see a trend?
Germany’s more or less in the same boat as Japan. Below we see negative interest rates all the way out to maturities of 15 years. And looking out to just 3-year maturities, we see a yield curve that is completely flat, if not slightly inverted. Once again a pronounced flattening over the last year is also evident.
Finally, the source of the market’s recent volatility, the United Kingdom (below). The same trend of flattening that we’ve seen in each and every chart is once again apparent here. We see a bit more positive slope than in the last couple of charts, but it’s hard to put much faith in this considering the wild market fluctuations (particularly in the currency) that we’ve seen recently.
Altogether, the yield curves of the top 5 economies paint a rather bleak picture. Over the last year, we’ve seen a major inflow into global bonds as investors look for safe ways of protecting their money. It’s either one of the largest examples of groupthink, or a signal that tough economic conditions lay ahead (or both).
So then, if the bond market is smarter than the stock market, and the bond market is signaling tough times ahead, why do stocks remain near record highs? Are stock market participants not listening to their “smarter” bond brethren?
I believe James Mackintosh of the WSJ put it best when he said, “Stocks are no longer about growth, but about a desperate search for safe alternatives to low-yielding bonds.”
Back during the heyday of quantitative easing, the acronym TINA was coined – There Is No Alternative (in reference to stocks). If that was the case back then, it surely remains the case now.
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As I’ve said many times, asset values are relative, not absolute. When the cost of money has fallen to nothing (or further), it no longer pays to be a lender. And if you take “lending your money” out of the available investment pool, what’s left? Equities and perhaps commodities.
So while it may seem that stock investors are not listening to what the bond market is saying, what choice do they have? We’re all essentially stuck between a rock and a cliff. The risk-reward dynamics in the current investment climate are poor, and safe, profitable investment opportunities are hard to come by.
Consider this simple comparison. The Dow Industrials (at these elevated prices) currently have a dividend yield of 2.5%, while the 10-year Treasury yields 1.4%. The broader market (as measured by the S&P 500) has a dividend yield of 2.2%, also handily beating that of the 10-year note. If you want/need yield, equities are some of the only places you’ll be able to find it.
The message that debt markets around the world are signaling is clear: watch out for weak economic growth ahead. One would think that the stock market would register this warning loud and clear, but with no other options, investors are forced to search in every nook and cranny for yield. This may have dire consequences in the years ahead, but for now, it’s keeping the stock market elevated and music playing.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
