The yield curve has been steadily declining since the end of QE3 in 2014. Historically, an inverted yield curve has preceded recessions. However, it is not until the yield curve starts to rise after being inverted that we should be on the lookout for the next major stock market correction.
In this issue we discuss:
- The impact of rising yields and what it can tell us about market peaks
- Investments in client portfolios designed to benefit from a rising interest rate environment
- The trend in the S&P 500 continues to push higher, while it appears that we are now in a rising rate environment, one not seen since the 1970s.
The yield curve chart shows the 10 year Treasury minus the 2 year Treasury history, one measure of the “yield curve”. The yield curve sits at 0.98% right now, meaning the 10 year Treasury rate is 0.98% higher than the 2 year Treasury rate.
There have been two official recessions over the past 20 years, one lasting from March 2001-Nov 2001 and from Dec 2007 – June 2009. Neither one of these recessions occurred when the yield curve was actually negative. Instead these recessions were occurring as the yield curve was rising.
A closer look at the chart reveals that the yield curve’s inversion actually didn’t result in a stock market decline. The declines in equities didn’t begin until the yield curve was rising. Although it may be a sign a recession is coming, quite often the market continues its bullish ways in the face of an inverted yield curve. Rather, once that yield curve starts to rise, that’s when we should be on the lookout for a stock market correction.
As called out on the left hand side of the chart above, when the yield curve is high it means longer-dated Treasuries offer more relative yield than shorter duration Treasuries. Similarly, when the yield curve is low (as it is now), shorter-dated Treasuries are likely the better end of the yield investment curve as we wait for the inevitable rise in the curve and thus more attractive rates. We have shortened bond duration to take advantage of a rising yield environment where shorter term yields don’t rise as quickly as longer-term yields. We have also positioned duration exposure in portfolios in such a way to potentially benefit from a rising rate environment. Being in shorter durations will be especially important if yields across the board are going to continue their recent ways. More details around that potential can be found in the Market Microscope section below.
Portfolios have exposure to multiple fixed income mutual funds that are positioned well, in our opinion, for a rising interest rate environment. We focus on two of these funds below. Many firms have been calling for a rise in interest rates for many years, and it simply has not come to fruition. The data appears to be telling us that rising rates are finally here.
Exposure #1: Floating Rate (Senior Loan) Fund
Investment Thesis: Generate current yield that increases as rates increase.
Commentary: This investment is positioned for rising rates by having exposure to corporate loans whose interest rates increase as general market rates increase. Many of these loans are tied to the 3-month LIBOR, shown in the chart above. Owning these types of investments are analogous to being the recipient of the payments from an adjustable rate mortgage. Your payments increase as rates rise, with relative stability in principle, unlike traditional bonds whose value may decline as interest rates rise. These are “senior” loans, meaning they are debt obligations that hold legal claim to the company’s assets above all other debt obligations. The primary risk in this fund is a deterioration in credit quality, typically associated with a weakening economic environment or outright recession. Weakening GDP or earnings would prompt a reduction in exposure to this fund.
Exposure #2: Diversified Income Fund
Investment Thesis: High current income with hedges against bond price declines.
Commentary: This fund is in the portfolio for two reasons: 1) Hedge against falling bond prices, and 2) Current yield is 4.61% with an effective duration of negative 0.70. What does this mean? Duration is a measure of a fund’s sensitivity to a change in interest rates. The higher a fund’s duration, the larger a corresponding move occurs in its price when interest rates move. Since this fund has a negative duration, we should expect the fund price to move higher if interest rates also move higher, which is what we expect to occur in the future. The table above shows various ways funds hedge interest rate risk. Fortunately, this fund does the hedging for us. This is an actively-managed, broadly diversified fund seeking multiple sources of income across a variety of bond markets. This fund employs strategies that seek to reduce interest-rate risk.
MARKET MICROSCOPE: Detailed Analysis of Relevant Markets
The bull market continues, even as we see the S&P 500 take occasional pauses. We continue to monitor for signs that the bull market that began in 2009 is coming to an end, but for now the trend remains up. The bond market has been where recent action is as yields have started to creep higher. Are we about to embark on another significant generational rise in yields?
Since the swift November and December rally the market has really embraced the Dog Days of Summer mantra. The first chart below shows us (by the green trendline) that the market really lifted off after the November Presidential election uncertainty was removed. Since then, although rising, the market has been much more tepid. After gaining around 9% in the one month following the election, the S&P has moved just 7% in the 7 months since (averaging just 1% per month).
The chart above as well as the next one leaves us with a small reason to start to get a little concerned, though. First thing to notice, on the far right side price has recently tested the yellow trendline in place since December. This reveals momentum has slipped to its slowest pace since that time period. A break of the trendline would then reveal a first since October, that momentum has turned negative, a precursor to a trend change.
The next chart below reveals a few other ways to measure trend. Trendlines, moving averages, and “Pivot Points” are all part of our FIT Model’s proprietary calculations, and two of the three are on the cusp of providing us some new signals. In fact you will probably see this next chart in this publication quite often because it actually hosts 4 key technical indicators used to objectively measure the stock market’s situation. Can you spot them?
Each of the blue boxes point out 4 indicators that are part of our FIT Model. How are each four doing?
First, in order of the callouts moving clockwise, there is a simple math calculation used by traders called “Pivot Points”. Pivot Points are a quick and easy calculation of the “average” price a particular entity traded at during the prior period. In this case that prior period is the month of June.
The numerous blue horizontal bars on the graphic mark the Monthly Pivot Points, and we can see all the way to the right that during the week of Jul 3, July’s Pivot Point (June’s average level of 2428) was broken below but quickly regained. A prolonged break below it would be a bearish development.
The second bubble calls out 2 moving averages, the 60 day and the 200 day, which together help us see both trend and momentum. When the 60 day is above the 200 day, momentum and trend are both strong. When the 60 day dips below the 200 day, that shows momentum has turned negative. If both the 60 day and 200 day moving averages are moving higher, then it shows us those trends are both higher, and similarly if both these moving averages are heading lower, that would be a bearish sign. Right now they are both strongly bullish, and with current prices above both these averages, that too reiterates the strong bullish trend.
The 3rd callout shifts to the bottom of the chart, which shows an indicator called the RSI. RSI stands for relative strength indicator and is a momentum measurement that looks at the current price versus price over the prior stated periods (in this case 14 days). More simply, if that line is declining then it shows momentum is also declining.
The blue line showing that decline is called a divergence. Divergences occur when prices are doing one thing, but momentum is doing another, and they are often present at key turning points in the market. In this case, indeed, price has been making new all time highs, but momentum has been slowing, and that is not a good sign for the intermediate term as it reveals a price that is rising but at a lesser pace than previously in this trend.
Finally, we also like to watch for extreme readings in momentum as the red ellipses outline. When momentum is overbought or oversold, it often coincides with a key market top or market bottom, respectively. Indeed the red ellipses did align with November’s lows, December’s temporary price high, and again with March 1’s top that lasted for 3 months. There is no extreme reading on this indicator at the moment. By looking at all of these different indicators, we can build a better picture of where we sit within the market’s trend. We add weightings and categories and can come up with a clearer picture of what to expect going forward, which is the primary goal of our FIT Model.
Our FIT Model’s current reading is “Consolidation within a Bull Market”. So, we remain in a bull market, but expect some sideways to partially down movement within that Bull Market over the coming weeks/months. We remain overall bullish equities with the expectation that this bullish trend’s end is somewhere on the horizon. Until that point, we remain fully invested to target allocations in equities.
Bond markets move in roughly 30 year cycles. Interestingly these cycles align with demographic generations. Those born in Generation X have seen their entire adult lives in a bond bull market. The baby boomers have been a part of two different bond markets, one of falling bond prices and rising yields in the 60s and 70s when they were young and another of rising bond prices and falling yields in the 80s, 90s, 00s, and 10s as they matured. We think both of these generations are about to see the next cycle take place. The chart below, from ZeroHedge, reveals the long history of the 10 Year Treasury Yield. What is clear is that bond yields do not move in a linear fashion and indeed move in more cyclical ways. Additionally if we look back at the history we do see about a 30 year cycle in bonds.
Looking back the last 100 years, in 1921 yields topped out near 5.6%. 24 years later, during WW2, yields hit a low of 1.7%. From 1945 to 1981, 36 years, bond yields rose drastically to a high of 15.8%.
From there yields fell to what we think is the next “generational low” at just 1.6%. That trend of falling yields lasted 31 years from 1981 to 2012. Today, the 10-year Treasury yield is at 2.3%.
Even before 1921, the prior trend low of 2.9% was hit in 1900, a 21 year trend. Before that, a high of 6.6% was hit in 1861, a 39 year trend, and so on and so on as can be gathered from the chart. To us it is clear that there is an average 30 year trend in bond yields, and if that is true then the odds that we have just witnessed a major low in bond yields has certainly increased with yields falling for 31 years and yields across the curve showing large moves higher.
As the chart to the right shows, we have seen Short Term Treasury yields as measured by the 1-Month Treasury bonds move up tremendously in just the last 1.5 years. The annualized 1 month yield is almost 1% from what was 0% in late 2015.
Perhaps more meaningful, especially if you have been thinking about refinancing your home, is the 30 Year Treasury Yield. It too saw a fairly large move in rates from just over 2.1% to over 3.1% in a matter of months (July 2016 to Dec 2016). It’s not a stretch to imagine 30 Year Treasury Yields back above 4% in short time, especially if indeed the 30 year cycle in bonds is moving back toward higher rates.
We have been shortening the duration of all bonds, where we can, in order to minimize the price hit they take as rates move higher. What this allows is for us not to get locked into a bond for a longer period of time than necessary, allowing us to reinvest more quickly into higher yields. We also have been looking at ways to hedge, in case the rise in bond yields is just getting started. After a 9 year lull in the short term Treasury (as the 1 month chart reveals), it’s hard not to look at the last 1.5 years and not conclude that a change in trend to higher yields is upon us.
Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.