Market signals have been decidedly mixed thus far into the year. By this time a year ago, the S&P 500 had already returned 5%. Today, in early May, the S&P 500 is down fractionally, while volatility and bond yields are up. We’ve been telling our clients for some time to expect a return to normalcy (i.e. higher market volatility), so we hope this year’s 10% correction in February, subsequent recovery, and then 7% correction in March hasn’t unnerved anyone too much.
Cross-currents of concern have been in the air and on the airwaves much of the last few months. On the one hand, given the recent fiscal stimulus of tax-cuts and the resulting significant earnings upgrades, many feel puzzled as to why the markets haven’t advanced steadily this year. On the other hand, the Fed has hiked short-term interest rates 4 times in the last year, and yet the longer-term bond yields have seemed largely immune for most of this period. This has produced a flattened term structure of interest rates, also known as the yield curve. Below is a depiction of the curve a year ago (blue) and today (green) from the Treasury’s interactive website.
A “flat” yield curve is a theoretical concern because longer term bond yields are typically thought of as good predictors of future financial conditions. Logically, one would expect significantly more compensation for the risk of making a thirty-year loan versus making a ten-year loan. Yet today, the ten-year Treasury yield stands at 2.97%, while the thirty-year yield is only 3.13%. The spread between the 2-year and 10-year Treasury rates is the narrowest it has been in over a decade. Short term rates have risen far faster than long-term yields, leading some to worry about an eventually “inverted” yield curve, whereby longer-term rates are lower than nearer term rates. John Williams, the new President of the Federal Reserve Bank of New York recently called inverted yield curves a “powerful signal of recessions”. There is an additional complicating fact for the market: the yield on the two-year Treasury is now higher than the yield on the S&P 500 for the first time in eleven years. This provides a choice for a segment of investors seeking yield without stock market volatility, which could imply an incrementally lower demand for stocks.
We recently sat down with Dan Ivascyn, Managing Director and Chief Investment Officer of PIMCO and posed the yield curve question to him. While he agreed that an inversion of the curve would be a bad portent, his view on the stubborn long-end rate was that it was at least in part due to the scarcity of high quality long-term assets. “Asset Liability” managers (primarily pension, bank, and life insurance investment portfolios) have high demand for long-dated, high quality bonds. We know the Fed’s balance sheet has tied up trillions of these bonds. This supply/demand imbalance has kept long-term yields low, even as the Fed has pushed the short-end up. Ultimately, Mr. Ivascyn insisted a flat year curve could last a long time—though he doesn’t rule out a parallel shift upward in rates across all maturities.
Back to the bright side. Disposable income has been rising, as has consumer confidence. Consumer confidence is closely correlated with consumption, which is responsible for roughly two-thirds of GDP. Housing starts, building permits and oil prices have all been firm—all indicators of a healthy, growing economy.
Today we are reminded of the glum outlooks we wrote about last year which seemed to permeate the start of 2017, whether it is pessimism surrounding stock valuations, the term “peak earnings” which has recently been added to the narrative, inverted yield curves and “late market cycle” references. Add a dose of long-absent market volatility, and it’s enough to slip into despair!