Investors Should Heed The Warning From Treasuries

Authored by Komal Sri-Kumar via,

Bonds, not stocks, have been the better predictor of the two recessions in the 21st century.

U.S. equities responded to the Trump presidency with euphoria. The Dow Jones Industrial Average rose 25 percent in 2017, becoming one of the best-performing global asset classes. It was a different story with U.S. Treasuries: The yield on 10-year notes fell slightly from 2.44 percent at the end of 2016 to close 2017 at 2.41 percent. And the spread in yield between two-year and 10-year notes, often a signal of slowing growth or forthcoming recession, plunged from 125 basis points to 51.8 basis points at year-end 2017.

As they receive different messages from equities and Treasuries, investors should pay particular heed to the bond market in making asset-allocation decisions for 2018. Treasuries have been a better predictor of the two recessions in the 21st century -- the first lasted from March to November 2001, and the second from December 2007 to June 2009. In the case of the latter, yields plunged during the months before the recession whereas equities remained strong well into the first half of 2008 when the economy was already in a downturn.

There is good reason to believe Treasuries are sending a warning now.

The bond market’s sense of caution in 2017 was not assuaged by the successful passage of the tax bill. While the yield on 10-year notes rose to almost 2.50 percent on Dec. 20 when it became clear the measure would pass and get President Donald Trump’s signature, it fell subsequently, closing the month little changed.

The surge in equities stemmed from corporate earnings that exceeded consensus estimates in recent quarters and, lately, the reduction in the corporate tax rate to 21 percent from 35 percent. Nonetheless, the decline in bond yields signals that the surge in equities may not be accompanied by faster economic growth or a significant pickup in inflation.

Narrower spreads between two- and 10-year Treasuries also reflect speculation that the Fed’s stated objective of raising the federal funds rate three times in 2018 may not be met. If the economy slows significantly after an initial burst of optimism over the tax cuts, the 10-year yield is likely to fall further even as the two-year yield rises with Fed tightening, eventually resulting in an inverted yield curve. Yield curve inversion was the harbinger of recessions in 2001 and 2007–2009.

While recessions have always been preceded by the two- to 10-year spread going negative, a negative spread has not always ended in a recession. For example, the inversion of the yield curve in May through June 1998 did not deter gross domestic product from rising in inflation-corrected terms by more than 3 percent in 1999 and during the first half of 2000.

This has led some market watchers to suggest that a potential negative spread should not be a source of concern. There are several reasons I disagree with this sanguine view.

First, wage growth remains anemic despite the quintupling of the Fed’s balance sheet since the financial crisis and the still-low interest rates almost 10 years later. This may not be offset by the recent tax package. Nonpartisan institutions such as the Congressional Budget Office have calculated that the benefits of the tax cuts are tilted heavily in favor of upper-income earners who are not major consumers. Consumption accounts for about two-thirds of U.S. gross domestic product.

Second, the new regulations incorporate reduced government spending on health care. This will discourage consumption by low-income and elderly Americans even as lower tax rates are intended to increase spending.

Third, a pickup in economic growth is contingent on companies responding to the lower corporate tax rate by hiring more workers and increasing their wages. Global competition from low-cost producers will limit U.S companies’ ability to achieve these goals, and stock buybacks and increased dividends are the more likely outcome. That is why the recent surge in equity prices is a logical outcome even as inflationary expectations remain low, resulting in lower bond yields.

In sum, as investors consider where markets are headed in 2018, they should be especially mindful of the message from the bond markets. From their current lofty valuations, equities cannot keep rising for long if bond yields and the economy do not cooperate.



LawsofPhysics Mon, 01/08/2018 - 11:21 Permalink

LOL!!!   This author still assumes that there is some remaining mechanism for true price discovery.

LMFAO!!!  FAIL!!!!

In the meantime...

"Full Faith and Credit"

same as it ever was!!!!!


MrSteve wisehiney Mon, 01/08/2018 - 12:49 Permalink

$UST20Y on stockcharts shows 50=200SMA, with yield north of both SMAs, so capital gains in TLT are negative today. Does anyone think long rates are going down to generate cap gains? Long bonds trading above par, TLT = 100, have a built-in capital loss of every dollar over par. YTM, yield to maturity is the measure of value to monitor for new investments in bonds.

In reply to by wisehiney

AGuy Mon, 01/08/2018 - 11:31 Permalink

"This author still assumes that there is some remaining mechanism for true price discovery."This author still assumes that there is some remaining mechanism for true price discovery."

Not a far stretch as the Fed is slowly raising rates. This appears that people are piling into 10UST's perhaps in prep for a sell off. I don't think foriegn CBs are buying USTs. Usually a market correction happens when stocks go vertical and it appears for the most part stocks have been going up vertical the past several weeks.


Margin debt has been going up & up. So it appears that stocks are become very leveraged. Excessive Margin debt will be the catalyst for a sell off. If there is a Dip, its likely margin debt will cause a forced sell off.



Sorry no predictions from me when the sell off will start, but I do have popcorn read for when the show starts. I presume that the CBs would step in if stocks sell off between 10% and 15%. I don't think they will permit a 2008/2009 sell off again.


Quantify Mon, 01/08/2018 - 13:28 Permalink

With a 15% tax reduction corporations SHOULD do well for the forseeable future. If the market rose under Obama it will certainly rise under Trump. Unless my magic beans aren't really magic at all.


TrustbutVerify Mon, 01/08/2018 - 14:40 Permalink

Keeping money in the United States by refusing to buy foreign goods would help immensely.  This includes so many American sounding brands that are little more than facades and are really foreign goods importers.  Imagine if for every billion dollars of spending a major percentage was switched from foreign manufacturing to being manufactured in the United States.  The pressure would be on for more hiring - hiring for real jobs.  Add to that the synergistic effects for (reasonable) tax receipts, help and stabilization of 

Imagine if Americans actually started to help themselves rather waiting on government to do something for them.  What a concept! 

whatisthat Mon, 01/08/2018 - 15:19 Permalink

I would observe all markets are highly manipulated and leveraged - by corrupt entities both private and government based, which result in  questionable markets performance and results.