Andrew Pyle
October 29, 2021
Bear flattener, but a bear market?
Since the depths of the pandemic economic recession, when interest rates plunged, market participants have debated as to when rates would stage a major reversal. This debate would hinge on the speed with which the global economy would return to full employment and how much sustained inflation pressure that recovery would create. More importantly it would depend on how much risk central banks would want to take in an environment where traditional macroeconomic models were thrown into the deep end without water wings. We are now seeing this debate shift as the market starts to lean more towards the prospect of nearer-term rate hikes.
You will hear analysts talk about the shape of a yield curve and whether it is flattening or steepening. The former refers to a situation where the gap between short and long-term bond yields is shrinking, while the latter is where that gap is widening. Typically, we think of a flattening curve as an indicator of slowing economic growth and the reason we think that is that usually a flattening curve stems from short-term rates being raised (like when a central bank starts to hike) and that eventually impedes economic activity. Well, sometimes. Let’s have a look at a common metric – the spread between the US 2yr and 10yr yields.
It is true that in times where the yield curve flattened and then inverted (when the 2yr yield exceeds the 10yr yield), US economic growth staged a vanishing act. Think of back in the 2004-2006 period, when the US yield curve flattened and then became inverted at the end of 2005. Year-over-year GDP growth moderated from around 4.5% down to just above 3%. Not too dramatic, though the drama would soon come. I remember this period vividly as it was right before I made the move from the institutional side of the industry, running capital market research at my previous firm. I would sit with my former boss and chief economist, analyzing the situation and concluding that a train wreck was coming. Of course, I did the logical thing and become a wealth advisor in the middle of that train wreck. But it provided perspective and, like much of economics, a historical study.
You see, it wasn’t just the fact that the yield curve flattened or even became inverted that caused the economy to nosedive into recession after the financial crisis. It was more to do with how long the curve remained flat and inverted. We would repeat this flattening again during the 2014-19 period and, while growth was kept below 4% during this period, the mood became very pessimistic in the summer of 2019. There were other factors at play in 2019. Like the value of negative yielding bonds in the world hitting a record high of around $20 trillion and a trade war with China. And, of course, the Fed had hiked rates to a whopping 2.5% - less than half of where the peak was before the financial crisis.
Did US economic growth collapse? In actual fact, we saw a revival in economic activity towards the end of the year – right before COVID-19 struck. The economy did fall into recession, but that was all pandemic and little to do with the yield curve. I will say this, however, and that without the pandemic, the economy was living on borrowed time. That brings me back to where we are today and the latest stirs of a flattening curve. Not just a flattening curve, but a bearish flattener – in other words, short-term bond yields rising faster than long-term yields.
This week, the spread between US 2yr and 10yr yields fell below 0.9%, which was the lowest since July. The flattening in July, however, was mainly because of a strong rally in 10yr bonds because of concerns over the Delta variant and its impact on growth. The 10yr has since sold off towards its worst levels of April as the market comes to grip with the possibility that inflation may not be “transitory” and that the Federal Reserve is going to buy less bonds. Yet, this development has more to do with how the 2yr bond has awoken from its slumber and corrected back to 0.5%. Why be concerned about a half a percent, you say? Well, the last time the 2yr yield was this level was before the pandemic. At the start of 2020, it was close to 1.5%.
And there is the rationale for the bearish talk in the market these past couple of weeks. While stocks continue to march to new record highs, there is a creeping concern that something unexpected might be brewing. The Bank of England and the Reserve Bank of New Zealand have started hinting towards a move higher in rates and the Bank of Canada is probably not too far back in the line given recent employment data. Let’s assume that economic conditions push the Fed to join the deli line and order a couple of rate hikes in 2022 and, God forbid, the European Central Bank contemplates taking rates back into positive territory (yes folks, the ECB deposit rate is still minus 0.5%).
As always, how do we reconcile the movements in the bond market with the stock market? I mean, before Amazon and Apple earnings disappointed after the bell on Thursday, the S&P500 had hit yet another record high and came within a few points of 4600. This has taken out my target for year-end and, suffice to say, it is probably beyond where most folks thought we would be 19 months after the market hit rock bottom when the pandemic struck.
I still believe there is fuel (pardon the pun) left in the economic tank and that equities have more tailwinds than headwinds. That said, we need to be mindful of a couple of important points. First, flattening yield curves work with a lag when it comes to economic activity and, hence, equity market direction. For example, the S&P500 peaked about nine months after the US yield curve reached the bottom of its inversion in November 2006. It only took a little over six months after the 2019 yield curve inversion for the equity market to peak, but that was because of the pandemic, right? What if the pandemic never happened (I know, if only)? Would stocks have peaked anyway in the summer of 2020 regardless? Did the counter-pandemic fiscal and monetary responses simply elongate the timeframe? I’m not going to pretend to interpolate that, though we have created a record long run for a bull market (again). The yield curve, despite its recent flattening, is not inverted. Bulls will say “wake me up when it does”. Some bears, however, may say that the inversion of 2019 is just taking longer to play out because of the pandemic. In short, stay nimble and that’s going to be our mantra for the fourth quarter.