March 25, 2019 glacierinvest

Year-to-date, the S&P 500 is up about 11.5%. Over the same time period, interest rates, as measured by the U.S. Treasury 10-year yield, have declined nearly 13% to 2.47% (as of 3/22/19). This trend appears to be sending mixed signals as rates historically have increased when stocks were on the rise in a typical business cycle. While this hasn’t always been the case 100% of the time, stocks and bond yields have a negative correlation over the long run.

The Gurus

On Wall Street, credit investors are often highly revered because they tend to get more conservative (see bearish) before equity investors towards the end of a business cycle, which has led many to believe that credit markets are the canary in the coal mine for the end of business cycles. Credit markets are an integral part of business cycle expansions and contractions but I’m not convinced credit investors know any better than equity investors when the end of the business cycle is approaching (disclosure: I’m an equity guy by training with a conservative bent). Sure, credit investors have had success historically getting in front of recessions, at least before equity investors. However, I’m somewhat skeptical this time around for the following reasons:

  1. Everyone has been trying to nail the end of this business cycle. I come across something at least once per week (usually many times more) talking about when the next recession will probably begin. Every time any part of the yield curve inverts, we hear about it and once again are informed how yield curve inversions nearly always predict recessions. A recession could be on the doorstep but what’s the limit on recession calls before an actual recession hits to quality for actually “calling” it?
  2. The stock market is up nearly four-fold since bottoming out in March 2009 while yields are 35bp lower than they were at the end of March 2009. We live in extraordinary times on many fronts and rising stocks and declining yields happens to be one of those fronts. Granted the correlation between the two over that time period is negative, the short period we’ve experienced in 2019 where the market has been ripping higher and yields have been declining could be a random blip in a longer-term trend. This wouldn’t be the first time this cycle we’ve observed this phenomenon. From the end of 2013 to the middle of 2016, yields declined over 120bp while the market climbed 19% (extraordinary monetary policy). An example in the opposite direction occurred this past October. The S&P 500 declined by 4% while the yield on the 10-year increased by 15bp. At that time, commentary focused on how asset classes that used to be negatively correlated were now positively correlated. Maybe we’re continuing to see an extension of that positive correlation trend, but even six months is too short of a time frame from which to draw meaningful conclusions.
  3. The Federal Reserve has done a 180 on monetary policy and may have gone from hawkish to dovish in the shortest amount of time ever (Note: I haven’t performed any analysis to support this claim). One could argue the about face supports a recession narrative. While that may be true, the Fed’s revised approach to its balance sheet is, on balance, bullish for Treasuries. Furthermore, the Fed’s outlook on inflation has become more benign, which if accurate, is bullish for long-term Treasuries. In other words, other factors could be contributing to the decline in rates beyond recession concerns.
  4. The decline in rates may be reflecting geopolitical concerns which arguably should show up in stock market performance but the stock market may have become increasingly numb to the theatrics playing out on the world stage. That’s not to say the issues don’t pose real threats but maybe their probabilities are so low at this time that the stock market has effectively “blown them off” until something changes to make them more probable.

The Bottom Line

We may or may not be in or on the verge of a recession. The credit markets may or may not be leading the way again as rates continue to decline. But what if they’re wrong? What if they’re being too bearish? What if this current trend is just an anomaly that will correct itself over the medium- to long-term? Interest rates and asset prices do funny things and don’t always act according to the rules humans have established for them. After all, we aren’t nearly as rational as we think we are.

A Closer Look

It’s hard to draw any discernible conclusions from the long-term chart below except stock market performance got a major rocket boost from the secular shift to lower rates that occurred over 30+ years. What’s interesting to note is that we’re not too far from the trough of previous long-term interest rate cycles. Of even greater interest, is the peaks of previous interest rate cycles were substantially lower than the peak of the current cycle (1980). There’s nothing to say that rates have to reach the levels experienced in the late 1970s/early 1980s again.

Interestingly, from May 1921 through September 1929 rates declined 170bp while the market increased more than four-fold, which is eerily similar to our current cycle.

Since 1981 through today, the stock market has been in a massive uptrend while interest rates have been in a massive downtrend (arguably the downtrend in rates shifted to an uptrend in the Fall of 2018. We’ll see if that holds with the Fed’s recent dovish pivot).


Data source for all charts: Online Data Robert Shiller