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From Curve Inversion to a Value Conclusion?


The hot topic of the week is the inversion of certain yield curve metrics as evidenced by the near hyperbolic increase in web searches for “recession” and “yield curve.” We have written about the curve’s inversion over the last 18 months and why the broad market interpretation may be a bit skewed today than it has in the past, with a few highlighted here:



First, the shape of the yield curve is always relevant, and the current situation is no different. The ultimate conclusion derived from the shape is still valid, however, the timing and magnitude of the signal needs a bit more context. As I wrote last week, the Federal Reserve not only continued their dovish pivot, they also shifted to more dovish action with ending tapering by September.


The futures have now priced in a 0% chance of a rate hike in the next 10 months but have also priced in a 79% chance of a rate cut and a 28% chance of two cuts. The curve has inverted on several curve metrics, but nearly all are based on those maturing less than two years and nearly any other metric in the intermediate term. This creates an inversion in that the short end of the curve will not adjust as dramatically until the actual rate cuts take place while the intermediate rates are far more influenced by market and economic activity. This alone creates an inversion, but one with an asterisk by it.


The inversion is also created by the historic measurement of quantitative easing that has gone on in the United States and – to a larger degree – globally. Here are some key measurements that need to be taken into consideration that did not exist to the degree, or at all, during the last three inversions (1998 market driven, 2000 and 2006). Source: Federal Reserve, Flow of Funds



  • The Federal Reserve Balance sheet as a percentage of federal government debt outstanding averaged 13.3% during the last three inversions. It currently stands at 22.1%, which means the Federal Reserve has created an assumptive market in which they are buyers of U.S. Treasuries during times of duress and will support it even though we are running at $1 trillion deficits.

  • The average time before a recession begins after an inversion has been in the 18-month range, on average, depending upon which recessions you include and which curve metrics you measure.

  • While the most common measurement has not quite inverted (The 10-year Treasury and 2-year Treasury), several others have. However, the more market-based spread that takes the economy and inflation has steepened. The 30-year and 5-year spread has steepened not only over the last six months, but after the Federal Reserve’s announcement last week. This measurement mutes the Fed’s control of the short end and gives a more market-focused measurement. Since its low set in July 2018, the 30-year and 5-year spread are back to levels last seen in late 2017, when the economy and market was expecting some of its strongest growth over the last decade.

  • Negative yielding debt has doubled from $5.7 trillion six months ago to $10.4 trillion on the massive risk-off global move and slowing global growth metrics. The mere massive number of negative yielding debt also constrains market rates rising in the United States as investors find even a paltry yield in the United States as far more attractive than negative-yielding debt.



Source: Bloomberg


The impact of the recent announcement has had a pronounced impact on interest rates. While the 10-year Treasury has declined 30 bps (basis points), The Bloomberg Barclays U.S. corporate index yield to worst has declined 25 bps and the municipal tax-free index has seen its yield decline 18 bps.


With the measurement of money flows back to historic levels in bond funds, we believe that the best option in the current market is to look at dividends as a main driver of results going forward. Last year brought about large metrics of stock buyback and earnings growth from the initial impact of the tax cuts, however, the amount of repatriation of foreign money was less than what most expected. As such, we see the accumulation of all the credit metrics resulting from the Federal Reserve’s announcement, and our case for the premature curve inversion, creating attractive levels of value relative to growth as being significant. We believe dividend stability and growth will be key drivers of return in the foreseeable future both on a relative basis and absolute measure.


 


CRN: 2019-0320-7319R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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