The Inverted Yield Curve
An Explanation of The Yield Curve
Happy Thanksgiving!
Wishing you all a very happy Thanksgiving!
Strong Upward Movement in the Stock Markets
This rally is what can be considered a short bear market rally.
Fed Is Not Going To Raise Rates
Fed chairman is reserving the right to raise rates.
The Confirmation Is In
All four major stock market indexes have turned negative.
A Few Indicators Confirming The Declining Economy
Economy is just barely hanging on…
Investing Circumstances Have Changed
Change of an increase in the rate of inflation
Pause in interest rate hikes
QUOTE OF THE WEEK “Charity, good behavior, amiable speech, unselfishness – these by the chief sage have been declared the elements of popularity.” – Burmese Proverb TECH CORNER The Federal Reserve announced a pause in interest rate hikes during the September meeting last Wednesday, therefore, the federal funds rate remains at a 22-year high of 5.25% to 5.5%. However, Fed Chairman Jerome Powell said at a press conference, “We’re prepared to raise rates further if appropriate and keep rates higher for longer.” The stock market really didn’t like his comments. Since the announcement, the S&P 500 is down -3.8% and the Nasdaq is down -4.3% as of this Wednesday morning, September 27th. With the threat of the government shutdown looming, the auto workers strike, oil approaching $100 a barrel and further bad economic news, the markets are starting to suspect this won’t be a soft landing for the economy. Our data is saying a worse scenario is already baked into the cake. If you think inflation is getting under control look at what car insurance premiums are doing. Auto insurance prices increased +19.1% from August 2022 to August 2023. From July to August alone, car insurance prices climbed +2.1%. So far in 2023, auto insurance rates on average have increased +11% year to date. SOURCE: Caring.com On a different topic, please read this important information: This situation just happened to one of our clients. Only a little over half (56%) of American parents have a will and/or a living trust document. Even when parents do have estate planning documents in place, adult children are mostly uninformed about where the documents can be found and what is written in them. Over half (52%) of adult children don’t even know where their parents store their estate documents, and 58% don’t know the contents of the documents. If this applies to your situation, “now” is the time to have the “conversation”. SOURCE; US Bureau of Labor Statistics, S&P Global
Nothing’s Changed
Still expecting a recession
The Big Debate…
Deep recession, soft landing or none at all.
We Are Getting Closer
There are many indicators that point to a recession.
Common Scams To Watch For
Don’t be the victim of a scam
QUOTE OF THE WEEK “When you practice gratefulness, there is a sense of respect toward others.” – Dalai Lama TECH CORNER Not much to report this week. So far this month the bond market is down about 3%, the S&P 500 is down 4% and the Nasdaq is down 6%. The stock market failed to break through its resistance level and is heading down. The bond market was hurt by Fitch, the rating agency, downgrading the U.S. credit rating from AAA to AA+.The data is still showing and we are still expecting a recession which is historically good for bonds and bad for the stock market. The recession is still not here yet and could arrive as late as the end of 2023. The trend of the data for the economy is definitely not positive.
What Is The Yield Curve?
QUOTE OF THE WEEK “When you practice gratefulness, there is a sense of respect toward others” – Dalai Lama TECH CORNER Let’s talk about the Yield Curve today and how it affects the economy. First what is the Yield Curve? There are multiple Yield Curve examples but today we will talk about the most common, the yield of the 10yr US Treasury vs the yield of the 2yr US Treasury. The math of the Yield Curve goes as follows: Take the yield of the 10yr and subtract the yield of the 2yr. The current 10yr yield is 4.21% and the yield of the 2yr is 4.95%. This computes to a negative yield of -0.74% thus an inverted yield curve. Now assume you are a bank and you are deciding whether to make a loan using only the interest rate example of the Treasury yields. Under normal conditions we have a positive Yield Curve meaning you take in deposits at say a normal 1% and you loan them out at 4%. Your profit is the difference of 3%. By the way, most long-term loans including mortgages, are tied to the 10yr rate. Now what we have is a situation where the Fed is raising the Federal Funds rate to control inflation. That rate controls the short end of the interest rate curve (2yr rate). So, in the example above with short term interest rates at 4.95%, you would have to pay sophisticated investors at that rate to attract deposits. Loaning that money out at the long term rate of 4.21%, it would be unprofitable to make the loan. In the old days most depositors were happy to get the low interest rate on their deposits. Now, sophisticated depositors aren’t satisfied being paid a low interest rate and are moving their deposits out of the bank and into short term rates via a Government Money Market Fund or buying 2yr Treasuries. Keep in mind that loans are the oil of the economy. So, in this case, you as the bank are seeing your depositors taking their money out to get a higher rate. What this means for the economy is that, again, you as the bank, are not going to make an unprofitable loan nor do you have the money in deposits to loan because your depositors are fleeing to get higher interest rates. The effect is that loan volume dries up and if loans aren’t being made, the economy slows down. The graph below shows what happens when we get an inverted Yield Curve as we have now, a recession (shown in grey) follows. This current yield curve is the most inverted going back to 1985. The probability of a recession following a period of an inverted yield curve has been 100%. The prediction of the political pundits and the news media is that we won’t have a recession or we will have a soft landing which may be highly improbable. Although I can’t say that won’t happen, we believe in data which is why we are positioned in bonds.
U.S Credit Card Debt
QUOTE OF THE WEEK “Gratitude makes sense of our past, brings peace for today, and creates a vision for tomorrow.” Melody Beattie TECH CORNER Not much to report. I did hear this morning that the US credit card debt officially just passed $1trillion. Combine that with the fact interest rates on credit card balances have gone up 5% over the last twelve months. That will eventually put a crimp on consumer spending. Gen Z is the fastest growing generation in piling on the debt. We are still positioned in US Treasuries of multiple durations in the managed accounts and we are positioned in intermediate duration high quality bonds in the annuities. Should a recession come as we anticipate, that the allocation will not change unless we get a signal that the recovery from the recession has started.
QUOTE OF THE WEEK “It does not matter how slow you go as long a you do not stop.” – Confucius TECH CORNER Last month we had a slight increase in interest rates resulting in a small decline in bond values. We currently own Treasuries and investment grade bonds at high interest rates. I expect we will be maintaining these positions for quite a while. These high interest rates should come down as we head into the recession which is good for us. Remember bond prices go up as interest rates come down. We are still convinced that we are headed into a recession. It just isn’t here yet. The stock market is of course not the economy, particularly when the Magnificent Seven “artificial intelligence” related stocks are up 49% while the other 493 stocks of the S&P 500 are only up around 2%. This same set of circumstances occurred in the Teck Bubble of 2000 to 2002 where any stock that in anyway was tied to the “new” internet roared up in value and the stock market eventually declined by 50% from the top to the bottom. My favorite saying back then was if the company’s name was “No Revenue No Earnings.com” it would rise in value. This rise in the Magnificent Seven has not been driven by profit increases but rather by having Artificial Intelligence associated with the company. Those companies are up a lot. This rally is not broad, it is very narrow. So far this year as to the stock market, it seems as though economic data doesn’t matter. But eventually gravity will win. Here are a few of the latest data points for the economy: China and European PMIs both slouched into deepening contraction. PMI stands for Purchasing Manager’s Index and are surveyed as to how much the companies are purchasing. This index is an excellent picture of the economy and if companies are not purchasing goods, that means the companies are expecting hard times ahead. South Korean export growth made a new rate of change cycle low of -16.5% year over year in July. Remember the US is part of the global economy. The Dallas Fed showed new orders declining to a fresh YTD low of -18.1%. The Fed Senior Loan office survey of banks showed further tightening in lending and an accelerating contraction in demand for loans. The Treasury increased its debt issuance target for the second half of this year to $1.85 trillion. Yes that’s right, this is just for the back half of this year with an annualized interest expense already at $1 trillion. And yes, that number reflects weaker-than-expected tax receipts and will get meaningfully worse if we fall into an outright contraction and tax receipts tank further. And yes, we don’t have the “cash” to pay that debt or the interest on it, so we will issue more debt just to pay the interest expense. Going forward the data looks pretty gloomy for the economy. We shall see how it plays out. Due the fact we own high interest rate bonds I think we are in a good position to weather any storms that maybe coming. Safe is the operative plan going forward.
The U.S. Consumer
Let’s tak a look at some statistics
Is a recession on the way?
QUOTE OF THE WEEK “With confidence, you have won before you have started” – Marcus Garvey TECH CORNER This week I am going to paraphrase from Stanley Druckenmiller, a famous asset manager, who has never had a losing year whom I happen to agree with. We both agree that a recession is on the way due to a year of aggressive interest rate hikes from the Federal Reserve trying to fight sticky inflation and that a hard landing is inevitable. There are more shoes to drop. This is really the Fed’s fault for blowing up an asset bubble in stocks, real estate, and other sectors by keeping interest rates low for so long after the Global Financial Crisis with their easy money policies. The Fed switched their policy in 2022 and started raising rates and we know that led to the dismal stock market returns for that year. High interest could lead to more issues in key sectors of the economy like what happened with the regional banks in March when Silicon Valley Bank rapidly failed forcing regulators to step in and backstop depositors. We now have an ailing commercial real estate market especially in the office sector as many employees are now working from home. Many of the commercial real estate assets are financed by regional banks which will put added pressure on them as owners start to miss mortgage payments. As I have stated before and I will go into detail next week, the banks capital is drying which has resulted in them just not loaning money. They are taking fewer risks amid slowing economic growth which is leading to a “credit crunch.” There is a lot of stuff under the hood in this type of environment due to the biggest and broadest asset bubble ever. When you add in a 5% interest rate increase in one year, the bankruptcies we have seen in the banks and other big firms such as Bed Bath & Beyond, it is most likely just the tip of the iceberg. The probability that a recession will come in the second half of this year is in the cards and it could be deeper than the so called mild recession or a “soft landing. The stock market always declines during recessions. The recent run up in the markets so far this year can’t be justified with earnings declining.. Earnings are expected to go negative for the second quarter of 2023. The warnings are dire and the economy is teetering on the brink of a hard landing and should it crash, it is likely that bankruptcies will surge, unemployment will jump over 5% and corporate profits will drop at least 20%.
Stock market rally this year
QUOTE OF THE WEEK“The secret of success in life is for a man to be ready for his opportunity when it comes.” -Benjamin Disraeli TECH CORNER This week will be a short letter. I am recovering from a shoulder replacement surgery of a previous replacement that went bad which is why I didn’t publish the letter last week. I am probably sure that you are wondering why we haven’t participated in the stock market rally this year. Don’t be fooled by this rally. It is a “false flag” rally. Only seven stocks are responsible for the returns so far this year. If you look at the other 493 stocks in the S&P 500, collectively they are down for the year. Earnings are declining and that should be evident when earnings reports for the 2nd quarter start coming out soon. Next week I will go into more detail as to why the stock market is headed for a fall. We are still positioned in US Treasuries.
The Fed Has Paused Raising Interest Rates
QUOTE OF THE WEEK “The secret of contentment is knowing how to enjoy what you have and to be able to lose all desire for things beyond your reach.” – Lin Yutang TECH CORNER As we expected the Fed has decided to pause raising interest rates. Chairman Powell said that they were going to follow the data, however he put the possibility of raising rates another 1/2 of a percent in the future. No guarantee, but I think they are done raising rates because the economy is continuing to slow. As stated before, when the Fed stops raising rates, long term interest rates will start to decline. As stated in the last letter we have allocated the managed portfolios in U.S. Treasuries over multiple durations from 1-3 year up to 30 year bonds. Last week the markets were up substantially with what I would call a “relief rally” due to the Fed pausing on their rate increases. Even with this rally, under normal conditions, stock prices will rise when earnings go up. Last quarter the S&P 500 earnings were flat. We don’t yet know what earnings will be for the second quarter, but the projections are that they will be negative so this may not be a sustainable rally. Everyone is excited by the year to date increase in the S&P 500 of 15.19%. Many are assuming that the bear market is over but no one is talking about the underlying statistic that is driving the performance of the S&P 500 this year. The performance of the “magnificent seven” stocks in the S&P 500 are up 78% year to date. In other words, the performance is being driven by only seven stocks. If you go back to the beginning of 2022, five of the seven are down, with some substantially down. One stock is up slightly, and one is up over 20%. Don’t be complacent as there are strong headwinds to the economy and the stock market going forward. The Purchasing Managers Index (PMI), the index that measures month over month economic activity in the manufacturing sector, is at 42. Anything below 50 is a contraction in manufacturing and every time the index has fallen below 46, a recession has followed. Due to the Debt Ceiling Debate the Fed has had to drain the Treasury General Account. This is the checking account of the Treasury. It was depleted down to approximately $50 billion to finance the government during the period when we were waiting for the resolution on the Debt Ceiling debate. The normal balance is around $1 trillion so this means they are selling Treasury bonds to get the account back up to the $1 trillion balance which will be taken out of the economy from people buying those bonds. One of the issues that will probably affect the economy going forward, is the fact that credit card balances have risen 17% over the last 12 months. Consumer spending is 70% of the U.S. economy but people are paying for living expenses using their credit cards. Add to that the interest rates have risen 5% over the last year leaving the consumer stretched and running out of money. Another component of the pandemic era relief for households is coming to an end. The debt limit deal struck by the White House and congressional Republicans requires that the pause of student loan payments will end by August 30th so student debtors will have to start making their payments again. This will also slow consumer consumption. The recession is right around the corner but how deep and how long is yet to be determined and keep in mind that the stock market declines with every recession. We are currently positioned in U.S. Treasuries of different durations with managed accounts and intermediate term bonds in the annuities. Sources: NY Times,. Time Magazine 576701.1
Confirmation That The Economy Is Slowing
QUOTE OF THE WEEK “Hard times don’t create heroes. It is during the hard times when the ‘hero’ within us is revealed.”– Bob Riley TECH CORNER Last week the Debt Ceiling Extension passed with 63 yes votes and 36 no votes in the Senate and 314 yes votes and 117 no votes in the House. It should have passed unanimously in both houses due to the unbelievable damage it would cause if not passed. I understand that certain members of the House and Senate on both the left and right needed to cater to their respective bases with a no vote. The betting is that it looks like the Fed is going to pause raising interest rates when they meet on June 13 & 14. There are already signs that this may be the last raise in interest rates because unemployment is starting to rise. Jobless claims totaled 262,000 for the week ending June 3rd. The total was well ahead of Dow Jones estimate of 235,000 and was the highest weekly rate since Oct. 30, 2021. A total of 1,635 million people were receiving jobless benefits through May 20th, up from 1,283 million from a year ago. It is important to understand that rising unemployment is a “lagging indicator” as to the direction of the economy. It is more than anything a confirmation that the economy is slowing which is exactly what the Fed wants to see. If all this is true, the Fed should stop raising interest rates which is a signal that long term interest rates should start to decline which is exactly the signal to invest into the bond market. It is also important to understand that all the “leading indicators” have been in decline for months. The groundwork has been laid signaling a coming recession. It now appears that the recession could be pretty deep. So, if you are considering jumping into the stock market, the risk is high and the rewards are limited. Please remember that the big stock market crashes since 2000 have all happened during recessions. The data says we are in the “eminent recession” phase, but we are really close to entering the recession. All of the data we follow suggests now is the time to enter the U.S. Treasury bond market. Last we allocated the Cambridge accounts to U.S. Treasuries of multiple durations from 1-3 years up to 30 years to diversify the risk. Remember when interest rates fall, bond prices go up. All the annuity contracts are currently allocated to moderate duration quality bonds. Sources: Department of Labor 5734526.1
Debt Ceiling Debate
The really big issue is the coming debt ceiling debate. We are the only country on the planet that has this stupid issue.
Oil in the engine
QUOTE OF THE WEEK “Our greatest glory is not in never falling, but in rising every time we fall.” – Confucius TECH CORNER The most recent update from Omega Squared, our investment advisory partner, is that we are not quite yet in a recession but we are getting close and looks like we will be there sometime in the next three months or so. Will it be a soft landing like the Fed is saying, or will it be a deep recession? It is tough to make an accurate predication but just like always we will let the data tell us. A couple of recent reports that don’t bode well for the future are NFIB Small Business Sentiment hit another new cycle low and U.S. Redbook Weekly Retail Sales remain in the doldrums at cycle lows for the second week in a row. What I really want to talk about is the most recent report of the Senior Loan Survey which is the survey of senior loan officers at the banks. This survey covers the period of March 22nd to April 7th, which is somewhat dated, and hasn’t taken into consideration the effects of what will come out of the debt ceiling crisis currently being debated in Washington. The survey is showing that commercial loan standards are tightening, loan demand is falling, and credit spreads are widening. This is the fourth consecutive quarter that commercial loans are falling and is now lower than the recessions of 1991 and 2001 but it isn’t worse than the Great Recession of 2008. Commercial real estate standards are significantly tightening and demand is notably weakening, especially for office space, as people who were working from home during the pandemic are not returning to the office. On the consumer side we are seeing credit tightening on credit cards, auto loans, and all other consumer loans. Every quarter the Fed asks a series of questions of the banks. Two of these being how and why banks are expected to change lending standards over the remainder of 2023. The answer was that over all loan categories, banks are expected to tighten credit over concerns of expected deterioration in credit quality of their loan portfolios and borrower’s ability to pay. The other concern in the survey to cause banks to draw back on lending, is that the banks are concerned about funding costs, their own liquidity, and deposit outflows. What does this all mean for the economy and the likelihood of a recession? It is important to remember that loans are the “oil in the engine” of the economy. Without loans businesses will have less capital to expand, potentially putting new initiatives on hold, or worst of all not be able to pay expenses or salaries. This slows the economy and then it turns into a vicious economic cycle downward. Sources: Hedgeye
