Yield Curve Uninverts - Now What?

Less than six months ago, the market was buzzing with the information that the yield curve inverted. As we all know, when the curve inverts there will be a recession. The time between inversions and recession is variable, but it will happen. It is a lock. Unfortunately, there can be false positives or more precisely, changes in the likelihood of a recession.

So, what do we do now? The curve has moved from inverted to being positive. This positive yield curve however is slight. The 3-month Treasury bill versus 10-year treasury bond yield is now positive 12 bps. The combination of Fed rates cuts and the announcement of Treasury bill buying to increase the Fed balance sheet is pushing rates lower. The Fed seems to be successfully offsetting fund tightness on the front-end of the curve, and some positive tariff news has pushed up yields on the long-end of the curve.

We can say is that the threat of a recession has been lowered. Most of the work on yield curve inversion and recessions has used logistic regressions to measure the probability of a recession event. The last reading from the New York Fed was slightly above 30 percent for September 2020, but that was with data from July. This likelihood measured while the curve was still inverted. That number will go down.

We are left with a measured response. The probability of a recession has declined. The Fed action and forward guidance has been enough to reduced the threat. Recession fears have diminished so holding a riskier portfolio is appropriate.

Current macro situation - Working through tariff supply shocks

Cutting through the rhetoric about tariff wars and the global growth, it is important to walk through a simple macro narrative that takes us to the current environment. 

Tariffs are supply shocks to the economy. They shock the cost structure for importers. Importers have to pay the price of the tariff and determine whether to pass-through the cost or reduce their margins. Exporters will see their product demand change given the cost of their goods have increased to their buyers. They have to lower their prices to help offset tariff costs. The supply chain is disrupted and import firms have to determine whether they change where they get their goods. This process will take some time, so the tariffs of last year are just now impacting growth. 

The Fed has responded to the supply shock by reversing its tightening policy. The impact of this reversal will also take some time to work through the real economy. The hope is that Fed rate reductions will offset the tariff shocks in the US and the rest of the world. However, the timing between shocks and monetary policy response may be off.

Unfortunately, there is also a higher uncertainty shock. Given uncertainty in policies and politics, the policy uncertainty index from the University of Chicago has exploded to the upside. This uncertainty will cause a delay with investment decisions. Who is going to commit to a longer-term project if the environment is unknown? Again, the hope is that a lower cost of capital from the Fed dropping rates will offset this uncertainty. 

  

During this environment we have seen the ISM diffusion index fall below 50 and global PMIs falling or at levels below 50. The tariff wars have had an impact on manufacturing, although the service indices are still holding up better on a relative basis. Generally, a rising ISM above 50 will represent a risk-on environment. A declining ISM will represent risk-off and a declining ISM below 50 risk can be viewed as a risk aversion environment. The bond rally corresponds with a switch to risk-off and risk aversion. 

The impact of these shocks will be seem in forward earnings. Earnings will  also become more disperse as firms in manufacturing will be hit harder than the service sector. These earning declines will lead to a reversal in equity prices. The financial markets push-pull will be between a further impact from the tariff shocks and uncertainty and the impact of Fed rate cuts. We are seeing downward revision of current global growth, but expectations of increases in 2020. The key question is whether global monetary policy has enough power to offset these shocks. 

Liability Driven Investing (LDI) could gain a boost through ARPs

Many pension funds that engage in liability driven investing (LDI) use the Bloomberg Barclay US Long Government/Credit Index as a benchmark, (LGC). This index is comprised of just over 40% in long government bonds and the remainder in credit sensitive bonds. To beat the index generally requires pensions to hold more corporate debt, especially lower rated bonds. 

Pensions that try and match the benchmark are taking risk in one dimension, credit exposure. We suggest that there are simple ways to diversify LDI matched portfolio while still gain the advantage of long duration instruments.

Pensions can use alternative risk premia as an overlay on a long Treasury bond portfolio. The investor will get the long duration exposure from the Treasuries while gaining return from the risk premia. However, instead of getting taking on risk in the form of credit carry through corporate debt, the pension can diversify into other risk premia. This type of overlay alternative is especially useful when credit spreads are tight. Since credit spreads can be replicated through equity and bond exposure,  the overlay can be  structured to hold similar but cheaper risk exposures. The overlay also can be structured to provide higher stand-alone return or returns that are less correlated with the credit cycle. In either case, this can reduce the pension's cost of liability matching. 

Inflation - Is it really worth following?

Remember when inflation used to be a critical number to track? If you now talk about following inflation to young portfolio managers, they will look at you as the old guy who raves about some by-gone era. The new monetary politics of MMT says that inflation may be something we will see in the future but don't bet on it. The same could be said about the secular stagnation crowd. Just focus on growth. Worrying about inflation is showing concern about a past problem that is irrelevant in today's environment. Inflation concerns from an 70's and early 80's experience is like the concerns of the generation scared by the Great Depression. One big past crisis clouds the economic events of today. 

It is easy to warn about the hidden dangers of inflation, yet that warning has provided to be false for a decade. Someday inflation may appear and you can say to all that you predicted it. The real issue is determining what to do if inflation stays well-behaved with core values between 1.5 and 2 and headline below 2.5 to 3 percent. 

It is hard to forecast higher US inflation when the rest of the world shows stable prices and there is no Phillips Curve trade-off. The reality is that local inflation is more closely linked with world price behavior and there is no inflation in either developed or emerging markets.

The number of countries with inflation above 2 percent is limited. Inflation as an emerging market problem is also limited. Now this may change given the move away from globalization and the reduced amount of slack in the economy, but recession fears and controlled inflation expectations make for an environment that is extremely inflation stable. 

The big winners over the last few years have been investors who have discounted inflation fears early. The continued winners may be those that continue to discount the threat of inflation.