Central Bank Liquidity and the Repricing of Risk (Part II)

As we began discussing in Part I of this blog entry, the research team at Montaka Global recently explored some of the major dynamics occurring in the fixed income markets, how they may impact stocks and potentially reveal some perspectives on what may lay ahead in 2019. Below is the continuation of that conversation, highlighting some of the key thoughts and observations we explored.

Convergence of Returns Across Asset Classes

• Since the start of October markets have been exceptionally volatile and risk assets have sharply sold off. This is highlighted by the convergence of year-to-date total returns across U.S. Treasuries, High Yield bonds and the S&P 500, despite having significantly different risk profiles. In fact an investment in risk free 2-year U.S. treasury bonds at the start of 2018, would have delivered a higher total return than an investment in the S&P 500 currently (+0.9% vs -0.9%).
• S. Treasuries are regarded as the global risk-free asset (the least risk), the S&P 500 represents the equity in the world’s most significant businesses (more risk), while High Yield bonds are largely a collection of weaker companies with poor balance sheets (the most risk).
• Given the wildly different risk profiles of the underlying assets across these three asset classes, it is highly unusual that the difference in total return between them is only ~1.0% currently after peaking at ~13.0% at the start of October. This represents a violent ~1,200bp repricing of risk, creating an extremely difficult environment to navigate.
• Furthermore, the credit market is highlighting a clear preference for shorter duration assets (shorter maturity) with 2-year U.S. treasuries outperforming their 10-year counterparts hence we may be receiving a signal that the bond market is rotating into shorter duration assets and given equities never mature (longest duration asset class) perhaps some of this bond market risk transition if washing up on equity market shores (more on this below).
• One thing is almost certain however, total returns on bonds and equities will not remain converged and inverted permanently, equity in high quality, undervalued businesses will outperform risk-free U.S. treasuries over the longer-term. The current situation is somewhat of an anomaly, and in certain cases may provide an opportunity to buy companies at a significant discount to their intrinsic value.

            Total Return Across Risk and Risk Free Assets (Year-To-Date)

• Another significant point of convergence is between the global cash proxy (i.e. 3-month U.S. treasury yields) and the average yield on global Investment Grade and High Yield bonds (i.e. Bloomberg Barclays Multiverse Index). Obviously getting the same yield on cash (3-month U.S. treasuries) as global corporate bonds may diminish the allure of other asset classes while the convergence remains in place.
• It is also worth noting that these two yields haven’t converged since the 2008 / 2009 financial crisis with the yield on 3-month treasuries steadily climbing since the first Fed rate hike in December 2015. Bond market yields have climbed since their mid-2016 lows, driven by tighter U.S. monetary policy and global synchronous growth expectations (both of which may be coming to an end).

3-Month Treasury Yields Have Converged with Global Corporate Bond Yields

Part of the U.S. Treasury Yield Curve Has Inverted, but the Key Recession Indicator Has Not (i.e. 10s2s Spread) 

• Over the last ~50 years we have seen 7 recessions in the U.S. and before each one the yield curve has inverted. Specifically, the 10-year U.S. treasury yield fell below the 2-year U.S. treasury yield (i.e. 10s2s spread). Currently this has NOT occurred (10s2s is currently +15bps) with the spread on the 5s2s (-0.5bps) very modestly inverted.
  • 5s2s spread inversion has limited predictive power in itself with regard to recessions, other than to perhaps occur ahead of the 10s2s spread inverting, however the timing between them is unclear
• Focusing on the last 30 years, we have seen 3 recessions in the U.S. and as we know, before every one of them the 10s2s spread has inverted. However, in addition to inverting, in all of those instances the 10s2s spread has steepened again prior to the recession.
• Looking at the chart below the instances where the 10s2s inverts and then steepens occurs when the white line dips below the red horizontal line (marked 0.00) at the bottom of the chart and back above again. Basically, we have seen multiple inversions before every recession over the last 30 years and beyond:
  • 1990-91 Recession: Curve inverted then steepened several times a couple of years ahead of the recession (shown below as the red vertical bands in the chart below);
  • 2001 Recession: Same as the 1990-91 recession however the inversions and steepness were very slight (hovered around 0bps);
  • 2008-09 Recession: Curve inverted twice ahead of the recession with the first inversion occurring at the start of 2006.
• From the first major 10s2s inversion in the last 3 recessions, it took to 12-21 months before the recession actually struck the economy, highlighting the forward-looking nature of this predictive indicator.
• Also, in the prior 3 recessions, after the 10s2s spread inverted for the first time, the S&P 500 (shown below as the yellow line), went on to and make a new all-time high before sharply correcting through the recession.
• If history is any guide, the prior two points may indicate that when the 10s2s inversion occurs and is followed by an all-time high on the S&P 500, a recession may be on the horizon.

                U.S. Recessions and the Inverting U.S. Treasury Yield Curve (10s2s Spread)

Key Takeaways fromCentral Bank Liquidity and the Repricing of Risk (Part I and II)

• Central bank liquidity withdrawal is expected to accelerate in 2019 with liquidity exiting the system as growth decelerates (opposite has been true over the last several years).
• Short-term U.S. Treasury yields have converged with global bond yields for the first time since the GFC, which may increase the attraction of cash and create an incremental headwind for risk assets in 2019 if this remains.
• Fed’s ability to maneuver at this point in the cycle is likely constrained with growth well above trend, unemployment at ~40 year lows, core PCE inflation now at target 2% and the Fed balance sheet is ~4x the size it was prior to the GFC already (may limit QE).
  • In the face of pressure the Fed seems to have paused its rate hike cycle,  it may still choose to end / slow its balance sheet normalization as well, however these maneuvers are unlikely to be sufficient to avert the end of the credit cycle permanently.
• Based on the last 30 years of recessions, once we see a 10s2s inversion (currently +14bps) we have seen a new S&P 500 all-time high before the recession actually hits the economy and the stock market sharply corrects.

These dynamics will likely create an even more challenging backdrop for asset allocation in 2019 than 2018, however weak and over leveraged businesses will be less able to hide behind a highly accommodative credit environment, which may lead to more defaults, expensive capital raising and more natural price discovery, particularly for the Montaka Global short portfolio.

Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.