The Chicken, the Egg and the Yield Curve

Have you been hearing huge sighs of relief lately? To understand why, look to the U.S. yield curve –that is, the graph of United States Treasury securities by maturity and yield that investors watch carefully as an oracle for predicting recession—which supposedly has returned to “normal.”

(Finance types: Skip this paragraph. Non-finance types: Maturity is the length of time until the principal, or amount borrowed, is due. Yield is how much investors are compensated for holding them, calculated as a bond’s interest rate –the “coupon”– divided by its price. Depending on how much the bond costs, then, the yield can be higher or lower than the interest rate.)

In a normal yield curve, the shorter the maturity, the lower the interest rate –for example, a three-month T-bill should yield less than a ten-year note. That makes sense, because there’s less uncertainty. In an “inverted” yield curve, it costs more to borrow shorter-dated securities than longer ones, because short-term uncertainty is high and investors can assume that over the long-term things will even out.

This matters because yield curve inversions have predicted all five of the last five recessions, typically preceding an economic downturn by about six months. Some past recessions, however, did not happen for a full two years after the yield curve inverted.

The US yield curve inverted this past March. Earlier in November, the yield curve returned to “normal,” or at least something passing for it.

So, yay, no recession, right? At least the stock market appears to think so, if we are to judge by the new highs in key market indices — now approaching the tenth record high this month.

Unfortunately, the yield curve righting itself isn’t in and of itself an indicator that we’re back on high ground, because flipping back doesn’t change the fact that the inversion happened in the first place.

Markets include a certain amount of self-reinforcing prophecy. Conventional wisdom –and US Federal Reserve policies– involve a certain amount of chicken-versus-egg “which comes first” logic.

If people THINK there is going to be a recession, that increases the chances that there will be one, right? So the way to prevent a recession is to keep people thinking that there won’t be one, right? And that’s by keeping stock markets up, right?

The stock market supposedly reflects investors’ expectations of how companies will perform going forward. After all, a share is a claim on future earnings. So as long as the stock market is strong, that keeps people thinking that the economy will be strong in future months. Or so the thinking goes.

But does the stock market “melt up” really reflect confidence in businesses and the economy?

In this case, it’s more likely that rising share prices suggest the opposite. As I see it, the record stock market highs reflect that:

1) Investors would rather put their money into securities propped up by low interest rates and Federal Reserve support of the market, rather than backing the real economy;

and

2) Investors believe that low interest rates will continue because they do not have faith that the economy will continue to grow or accelerate.

Here are some other indicators that may tell us more about the attitudes and financial conditions of companies, which are better indications of recession.

The Wall Street Journal reported this week that capital spending by S&P 500 companies rose by just 0.8%, or a combined $1.38 billion, from the second quarter to the third quarter of 2019. It suggested that an uncertain business environment was prompting some companies to postpone or shelve otherwise promising projects. And, if you exclude the $1.9 billion by which Amazon and Apple together raised their capital spending, it appears that spending fell at the other 438 reporting companies.

Compared year on year, spending is down and has been falling over the past year (follow the link for numbers, which change as more companies report). What’s more, companies now are easing the gas on share buybacks, which have been supporting the stock market.

Yardeni Research analysis shows that second-quarter buybacks of S&P 500 companies fell in the second quarter for only the second time since 2017, after companies bought back a record amount, more than $1.1 trillion shares, in 2018. When the next set of buyback numbers come out, if they have continued to fall that will be a telling indicator that companies not only are not investing in themselves, they see investing in their shares as a less attractive proposition too.

Finally, with corporate debt also at record levels, if interest rates do not stay low, more companies are at risk of missing interest payments. As Bank of America’s chief executive officer, Brian Moynihan, put it earlier this year in a warning on highly indebted companies that have issued leveraged loans: “It’ll be ugly for those companies if the economy slows down and they can’t carry the debt and then restructure it, and then the usual carnage goes on.’’

As Sven Henrich of Northman Trader puts it: “corporate debt is a massive problem, it’s a ticking time bomb that millions of workers get to pay for during the next recession.”

Many of the smartest economists I know have been screaming into the wind for some time now that super-low interest rates are merely pumping up global securities markets far more than they are helping the real economy.

But that can’t go on forever. Right now, the chicken-and-egg relationship between the market and the economy is scrambled. And make no mistake: the markets are going to lay an egg. It’s only a matter of time.

This article is part of my new LinkedIn series, “Around My Mind” – a regular walk through the ideas, events, people, and places that kick my synapses into action, sparking sometimes surprising or counter-intuitive connections. 

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