Shots Fired! Is the Yield Curve About Steepen?
Trouble for risk assets creeps closer as the flat yield curve (and in several terms inverted) begins to steepen with short-term rates falling faster than long-term rates. The US 2-year yields just broke below the previous weekly cycle low of Dec 2018. While the US 10-year and 30-year yields are basis points away on the verge of breaking down too. TRI expects the 2-year yields to fall faster than the longer dated treasury bonds, causing the yield curve to steepen over the next 12 months.
Meanwhile in equity markets, the S&P 500 has managed to make new highs on more pronounced negative divergence with the RSI indicator and several other key markets. As seen below, none of the NYSE Composite, Russell 2000, Emerging Markets or the World Ex-US ETF’s have been able to make new cycle highs. This is very troublesome for TRI, as it signals major market weakness disguised behind the strength of US mega cap stocks.
The historical US10Y – US2Y yield curve provides some very interesting information as we enter the next phase of the business cycle. On 3 occasions – 2004, 2010-12 and 2014 – in the last 15 years the US10Y-2Y yield curve peaked above 2.5%, after a period of flattening. Although the time frame, economic back drop, inflation, employment levels, central bank support and global trade dynamics are not directly comparable in each of these phases, we know that once economic weakness begins to be recognized the yield curve steepens at least 1.5%. Even more telling is historically, US short-term rates tend to fall over 3% as the business cycle peaks and rolls over, especially after the Federal Reserve has been on an interest rate hiking cycle.
With each business cycle roll over, the short-end of the yield curve begins to fall faster than the long-end, the curve steepened. The curve steepening wasn’t always immediate, but over the medium term it helped facilitate lower short-term policy rates. This in turn primed the economy for a new business cycle (TRI expects new business cycle to begin in early to mid 2020). If short-term interest rates fall 3% from cycle peak, that would get rates back to 0% … and potentially turn some portions of the yield curve negative, especially given the likelihood of further rounds of quantitative easing.
As seen below, since Jan 2019 the US10Y – US2Y curve is creating a base and is creeping higher. This doesn’t mean that the curve won’t flatten some more or take more time before accelerating higher. It does mean, the economy is likely past its peak growth and likely to slow materially over the next 6 to 12 months bringing down short-term interest rates with it.
Risk are elevated as risk assets complete their topping process. TRI favors defense and liquidity in current market conditions.
TRI Cycle & Trend Signals*
The TRI Cycle and Trend Signals are shown below. These signals are as of market close on May 17, 2019. Please see the TRI Overview document for further information.
Source: Fieldhouse Capital Management
* TRI Cycle and Trend Signals are dynamic and may change on a daily, weekly and monthly basis, without notice. The indicators are at a point in time and do not imply that the current trend will persist and should not be considered investment advice.
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