April 1969 saw the release of what would soon become Credence Clearwater Revival’s second gold single. Bad Moon Rising’s popularity quickly secured it a permanent spot in rock history. But it was also headed somewhere else, if not everywhere else, to places the young rockers never saw coming. In hindsight, it can only be said that while their music was great, their lawyer was lousy.
Why is that? Because, for years now, writers for both the big and small screen and all manner of productions have found the song’s addictive rhythm and lyrics impossible to resist and as a bonus, easy picking. Listen and you’ll hear it in An American Werewolf in London, My Fellow Americans, Twilight Zone: The Movie, Blade, Sweet Home Alabama, My Girl, Man of the House, Mr. Woodcock and (in the personal favorite department), The Big Chill. As for television, you’ll recognize the tune in Supernatural, Cold Case, Northern Exposure, The Following, The Walking Dead, Teen Wolf, and not to be relegated to the back of the line, Alvin and the Chipmunks, who belt out their own immensely irritating rendition.
There’s no doubt about it. John Fogerty hit a home run when he wrote Bad Moon Rising. As to why he wrote it and its meaning, he’s been quoted as calling it a description of, “the apocalypse that was going to be visited upon us.” And what of all those bad scenes visited upon Fogerty’s lyrics?
“We had no power in our contracts to veto where our music went. It was everywhere,” lamented Fogerty on the ubiquity of the song in a 2014 interview. “For every good movie you’ve heard it in – for example An American Werewolf in London, which was a pretty cool movie – there were at least 10 more that were awful.” To this day, it’s hard to predict just where that bad moon might next be rising.
The same cannot be said for investors, who happen to have a perfect predictor with which to position themselves for their rendering of a bad moon rising, as in an imminent recession. It’s called the yield curve and when it inverts, it’s time to start pondering the ramifications of the apocalypse that’s about to be visited upon the economy. Is ‘perfect’ too perfect a word?
In one word, no. In a different 2014 setting, back when he worked for LPL Financial, Schwab’s Jeffrey Kleintop noted that the yield curve’s track record was seven-for-seven, as in perfect when it came to predicting recession. Business Insider caught his remarks.
In the event you’re unfamiliar with the contorted concept, visualize a curve on a graph. Plotted are the bond yields (assume U.S. Treasurys in this case) against the length of time that remains between now and their maturity date. In a normal world, the shorter the maturity, the lower the yield. Investors should naturally expect to be paid less and less as the period of time shrinks over which they’ve assumed the risk of a bond price declining. With me? Hold bond for longer, chance price decline occurs higher. Got it.
An inverted yield curve, however, signals an economy is about to be turned upside down. Longer term yields tend to decline when the market foresees weak economic activity on the horizon. The weaker the outlook, the flatter the curve. Actual inversion is thus a process; it might begin to manifest in five-or-ten-year Treasurys having higher yields than the Long Bond, the 30-year. A full blown inversion doesn’t occur until the yields on the shortest-maturity, commonly quoted bonds, say the two-year, are higher than that of the longest maturity bonds.
To borrow from Kleintop’s succinct explanation: “The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from five to 16 months.”
As for the lead time leading up to the lead time, the U.S. Treasury curve began to flatten at the start of 2014. You may recall that in December 2013 the Fed announced it would begin to taper its purchases of securities, which at the time were $85 billion a month, and in doing so reduce the pace at which it was growing its balance sheet. Despite it being well past the time to start weaning the market, it didn’t take long for the worry to set in. Investors began to digest the prospects for the U.S. economy without the Fed blowing up its balance sheet in an attempt to stimulate the growth that eludes to this day – and they didn’t like what they saw.
The second volley arrived last December when the Fed finally hiked rates for the first time, triggering a further flattening in the yield curve. But wait. Wasn’t it just one teensy quarter of one percentage point? Well, yes. But as far as the bond market was concerned, starting points and deltas mattered.
The latest kick to the curve started with New York Fed President Bill Dudley’s and Federal Reserve Board Vice Chairman Stanley Fischer’s complacency castigations. The crescendo arrived with Janet Yellen echoing her two top lieutenants in sounding a bit more hawkish than she would have otherwise. The camaraderie on full display captured in images of the threesome emerging from the Jackson Hole meeting was the proverbial icing on the cake. It was sufficient to send the difference between the 10-year and two-year Treasury to 75 basis points, or hundredths of a percentage point, about where it is today.
In the event you’re still wondering what all the fuss is about, I’ll let Kleintop sum it up: “The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.”
But wait, you might be saying – we’re already in a full blown, protracted profits recession. Recall that Kleintop made his observations in 2014, long before the heat of the currency war really set in, triggering a race to the bottom of the unconventional monetary policy barrel. You just thought Quantitative Easing (QE) had long since ended. That’s true, but only as it pertains to the Fed.
In fact, you might not know it, but a two-year anniversary is upon us. Surely those in the Fed will raise a glass this October 29th to commemorate the end point of their ambitious exercise to expand the bank’s balance sheet. That is, unless they’re already contemplating Blowing Up the Balance Sheet, Part II.
(Don’t misunderstand. Those firmly in charge have always maintained that they would never dare allow the assets on the balance sheet to run off until rates were normalized and they pretty much knew that would never happen. In fact, the current campaign aims to move even those goalposts so the stated goal of normalization is that much more impossible to attain. What few appreciate is this is where the real action has been in recent years, the very source of animated discussions around that big conference room in the Eccles Building. Reinvestment, baby. That’s where it’s at. Pardon the lengthy digression.)
Getting back to the point of the yield curve, or what’s left of it, over the past two years, other central banks have more than made up for the Fed’s exit from the QE game. Aggregate purchases are nearing $200 billion per month creating a vacuum across other countries’ yield curves as the supply of eligible securities with positive yields dwindles.
According to the Financial Times’ math from earlier this month, “Three years ago the difference between two- and 10-year Treasurys, gilts (U.K.), Bunds (Germany), and Japanese government bonds was about 228 basis points (bps), 201 bps, 150 bps and 65 bps respectively. Despite a slight reversal, the same spread now stands at 87 bps, 61 bps, 55 bps and just 9 bps.”
The relative flatness of other major sovereign’s yield curves helps explain the rush into our Treasury market, all to secure some semblance of yield vis-à-vis the increasing number of countries whose sovereigns sport not just low, but increasingly negative yields. According to Bank of America Merrill Lynch data, at last count, we’re talking some $13 trillion, or roughly a third of the global fixed income debt market. (In case you missed it, that was a WOW moment.)
You may be wondering at this point — hopefully you are — why on earth the Fed would be trying to beat the band to hike rates when all they’ve got to work with is roughly 75 bps, give or take?? These days that question is raised just about every minute of every day, namely because so few can come up with a credible answer.
As for the incredible realm, one explanation is that the Fed is scared stiff it has nothing left in its toolbox to combat the next recession. Few major downturns have begun with the fed funds rate so perilously close to zero.
The ultimate Catch 22 is that the flatness of the yield curve makes any fantasy of a Fed rate hike all too real for a dead breed the world once knew as ‘bond market vigilantes.’ It’s altogether possible that one more hike would be all it takes to invert the yield curve. The rest, as history has never failed to repeat, would be just that – history. Should the Fed decide to ignore the warning flashing in the flattening yield curve, there could indeed be a bad moon on the rise over the U.S. economy.
The US economy may not be as strong as it looks
Thus, the UBS macro strategy team put together a chart of major indicators for the US economy and where they stand compared with the most recent time the Fed raised rates in December and where they were two years ago.
Overall, the chart from Daniel Waldman and company does not make the US economy look very encouraging.
UBS’ argument is that for the Fed to raise rates, the economy has to look substantially better or at least not worse than it did when the Fed most recently hiked. Thus, the Fed should stay on hold (and the UBS team thinks it will).
The strategists believe that a strong jobs report on Friday could help cover the Fed if it does want to hike rates in September but that the rest of the economic data isn’t that good.
“Although labor market data is key, one additional positive employment report is unlikely to completely change investor sentiment on US growth, which has softened relative to both late 2014 (when the dollar started to rally) and late 2015 when the Fed last hiked,” Waldman and co. said.
A few caveats here. First, UBS analyzed just a handful of indicators. Wage growth, personal consumption, new home sales, and other indicators of economic strength have set cycle highs since the most recent Fed meeting.
Second, payroll growth is expected to slow as the labor market nears full employment because the number of available workers declines. So a headline decline isn’t a terrible disappointment.
Third, there’s an argument to be made that inflation has been weighed down by temporary factors.
Fourth, the manufacturing number is actually worse than the chart indicates, with the latest reading coming in at 49.4 on Thursday, which is back in contractionary territory. So the UBS chart doesn’t look great, but it isn’t the fullest of pictures either.
Regardless, it’s not as if the economy has been gangbusters since the last time the Fed hiked rates, and that may keep it on hold.