The market provided a proverbial “gotcha” last week as concerns over trade wars and yield curves were still weighing on the markets. The S&P 500 SPX closed down more than 90 points (or -3.24%) on Tuesday ahead of the market being closed on Wednesday (12/5) for the National Day of Mourning for former President Bush. All told there have been 57 days this year where the market has closed +/- 1%, which we will define as a “volatile” day. Through the end of last week that means that 24% of the days this year have been volatile, which is right at the historical average.
In case you’re wondering, 29 out of the 57 “volatile days” in 2018 have come in October, November, and December, while February of this year actually saw 12. Interestingly enough, the only year (so far) in the past seven years that saw an above average number of “volatile days” was 2015, which saw nearly 29% of the days move +/- 1%. There have only been two years in modern history that saw 50% of the trading days as “volatile days” – 2002 and 2008. On the other end of that spectrum, the return of volatility in 2018 comes after a year that witnessed the lowest amount of volatility in more than 50 years, as just over 3% of the days in 2017 were +/- 1%.
As I mentioned above, there is some concern about the yield curve and the role it may have on the stock markets late in the cycle. The yield curve is a graph of Treasury yields. Recall that the U.S. Treasury Department sells its debt in various maturities. They are:
- One-month, two-month, three-month, and six-month bills.
- One-year, two-year, three-year, five-year, and 10-year Treasury notes.
- 30-year bonds.
In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period; they require a higher yield to give them more return on a long-term investment. During healthy economic growth, the yield on a 30-year bond will usually be three % points higher than the yield on a three-month bill. An inverted yield curve occurs when the yields on debt with a shorter duration are higher than the yields on bonds that have a longer duration. It's an abnormal situation that often signals an impending recession.
When a yield curve inverts, generally it's because investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. They perceive the near-term as riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term. So, in essence, an inverted yield curve means investors believe they will make more by holding onto a longer-term Treasury than a short-term one. They know that with a short-term bill, they have to reinvest that money in a few months. If they believe a recession is coming, they expect the value of the short-term bills to soon decline. Why? Because they know that the Federal Reserve lowers the fed funds rate when the economy slows and short-term Treasury bill yields track the fed funds rate.
As investors flock to long-term Treasury bonds, the yields on those bonds fall. Remember, as the prices of bonds rise, the yield falls. These long-term Treasuries are in demand, so they don't need as high a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors. Eventually, the yield on short-term Treasuries rises higher than the yield on long-term bonds and the yield curve inverts. Recessions last 18 months on average. If investors believe a recession is imminent, they'll want a safe investment for two years. They'll avoid any Treasuries less than two years. That sends demand for those bills down, sending their yields up, and inverting the curve.
On December 3, 2018, the Treasury yield curve inverted for the first time since the recession of 2008. The yield on the five-year note was 2.83%. That was slightly lower than the yield of 2.84% on the three-year note. On December 4, the inversion worsened as the yield on the five-year note was 2.79%, while the yield on the three-year note was 2.81%. Essentially, bond investors were betting that the economy will be a bit better in five years than in three years.
This small inversion could be temporary. If it continues or worsens, then it could foreshadow a recession.
Until next time, cheers!