The first two parts of this series were originally posted on Seeking Alpha.
In part I of this series, I started at the front-end of the yield curve, actually discussing Federal Funds Futures, as well as touched on short-term interest rates, to understand what the market is currently pricing in.
Based on the data, the market is not overly concerned with growth in the short-term. While I don’t agree with this assessment, the market is clearly pricing in roughly one interest rate cut over the next two years.
The market is running on the expectation that our current environment is similar to that of 1994 or 1998 in which global economic weakness created a soft patch for the US economy. Various measures of the yield curve compressed sharply and the Fed cut rates several times, re-steepened the curve, and the economic cycle continued.
Fed Funds Futures Curve:
In the second part of this series, we discussed the middle of the curve, including the ever-popular 2s10s spread to gauge the market expectations several years from today.
The bond market is implying, based on the shape of the yield curve, that growth will slow dramatically relative to 2018 in the next several years, but that no recession will develop and one rate cut from the Federal Reserve will be sufficient to help the economy recover from the global economic weakness we are seeing.
Many use the 2s10s spread as the ultimate barometer of recession probabilities or growth expectations, but as we have seen through part I and part II, there is information to be gathered from all areas of the yield curve with varying degrees of reliability.
To summarize briefly, the market expects roughly one rate cut in the next two years, slowing economic growth, but without a recession.
If you have a different view than that which the market is currently pricing in, you can exploit that view in the bond market or the stock market or various other assets that are impacted by changes in interest rates, including currency pairs.
Based on the current economic data and the models I have to analyze the current growth rate cycle, I agree that growth is slowing and will continue to slow. The growth cycle slowdown that I anticipate will require more than one rate cut. With that said, a recession may develop but that is not anywhere in the economic data yet — so without hard evidence, I am not making a recession forecast.
To confirm that view of a recession, we must now move to the back of the yield curve and assess the opinion of the ultimate long-term economist, the 30-year bond yield.
Long-Term Expectations / Recession Fears
The 30-year bond yield is the best measure of economic activity and future inflationary pressures in an economy. Also, the 30-year bond yield is the least subject to influence from the Federal Reserve and other central banks, deriving its value exclusively from credit risk (or lack thereof), growth expectations and inflationary expectations.
Since this series is about the yield curve, let’s look at various spreads using the 30-year yield as our anchor.
Unlike the 2s10s spread, which can give a false signal such as in 1998 when the curve briefly inverted, the absolute best measure of recessionary expectations is the 30-year yield minus the 3-month yield.
The longest-dated bond is the best economist and the 3-month yield is the most influenced by the Federal Reserve, more or less tethered to the Fed Funds rate.
While an inversion of the yield curve is not a necessary requirement for a recession, if the 30-year yield falls below the short rate, that is a major signal from the market to the Fed that a recession is approaching and rate cuts need to occur swiftly.
Today, there are about 61 basis points separating the 30-year yield and the 3-month rate and the trend remains one of rapid compression.
Without a rate cute, the 3-month yield will be more or less tied to the 2.40% range. With the 30-year yield sitting at 3.05% as of this writing, it is possible an inversion can occur in 2019 if US conditions deteriorate further. For now, the market is simply pricing in growth slowing but not a recession (yet).
30-Year Yield Minus 3-Month Yield:
If we compared the 30-year yield to other maturities closer to the middle of the curve, we can see steepening occurring in recent weeks. Why is the back end of the curve steepening while the front-end is inverted?
The 5-year rate fell sharply from 3.09% to 2.45% today. This plunge occurred when the market shifted expectations from 2-3 additional rate hikes to one rate cut. This change in expectations caused a 65 basis point drop in the 5-year rate.
The 30-year yield dropped from 3.45% to 3.05%, a 40 basis point drop, thus steepening the curve.
The 30-year yield was not able to drop an equal amount as the 5-year rate, which would have shifted the curve lower in a parallel fashion because without the Fed moving the short-term rates, this would have pushed the yield curve closer to an inversion than economic conditions warrant.
Given that the market shifted from rate hikes to rate cuts, without a recession, a steepening of this spread was the result.
A similar situation is occurring with the very back end of the curve. The 10s30s spread has also been steepening after hitting a low around the summer of 2018 when rate hike expectations were highest.
Again, an inversion of any particular spread is not a necessary condition for a recession but if the curve does invert, that is a likely recession signal as credit growth halts.
A steepening of the 10s30s spread, without a recessionary signal identified by other spreads, suggests that the market is most worried about short-term risk relative to long-term risk (aka a recession).
After analyzing the entire curve, front to back, we can now have a firm grasp of exactly what the market is pricing in over various time durations.
We can then use our own analysis to find the largest mispricing between current market expectations and our expectations based on data-driven analysis.
To summarize, the market expects the economy to experience a soft patch, requiring roughly one rate cut over the next two years. Given the lack of recessionary concerns in the medium term and long term, this shift from 2-3 rate hikes to one rate cut steepened some of the spreads across the curve.
Based on my analysis and expectations for the future, the curve is mispricing the likelihood that the Fed has to lower rates more than one time over the next two years.
This will result in a shift lower of the entire yield curve and lower interest rates across the curve.
The bond market is cautious in the short-term but not overly concerned (yet) about a recession. The risk of a sharp economic slowdown is likely larger than the market is currently giving credit.
Lastly, this note is not about the stock market, but looking at expectations for earnings growth in the S&P 500 is quite stunning given the outlook from the bond market.
Below is a table that shows the S&P 500 current EPS expectations.
S&P 500 EPS Estimates:
The bond market thinks growth will be slowing based on various measures of the yield curve yet the stock market believes EPS growth will be 5.3% in 2019 and 10.80% in 2020.
This is not a short-term forecast but either the bond market or the stock market is wrong here.
In time, these expectations always converge, sometimes swiftly as we saw in December of last year.
I will go with the market that has a better track record of forecasting economic conditions.
If you would like to receive further analysis, you should consider my premium research service EPB Macro Research.
Eric Basmajian is the founder of EPB Macro Research, providing easy-to-understand economic analysis as well as presenting two model portfolios he believes are best suited for current market conditions — so your portfolio is always protected from the next shock.