This Part of the Market Is Still 'Growing Negative'

One burning question... Revisiting the yield curve... This part of the market is still 'growing negative'... Last seen in 1981... It's not all bad news... The Federal Reserve owns $5.5 trillion of Treasurys... What they're saying now... Proceed with caution...

This is one of the burning questions of the moment...

Paid-up subscriber Matthew A. wrote in after reading yesterday's Digest, where we talked about the U.S. dollar taking an elevator ride down lately...

I don't understand why the yield curve is growing negative, even with the rate hikes. The 2yr to 10yr is up to [negative] .60.

When does this change? Do we have to wait until the Fed gets into real rates? And, it seems like the market doesn't want to listen.

There are a lot of great thoughts and observations embedded in this note.

I (Corey McLaughlin) love it, especially the part about "the market doesn't want to listen." That's a critical point to always keep in mind... The market doesn't necessarily care what we think.

As always, we welcome your comments and questions. Send them to feedback@stansberryresearch.com. Today, let's get into this one...

Why does the yield curve keep "growing negative"?

The answer – or at least the exploration of an answer – speaks to the possibility that as we speak, the market is baking in a few years of "new expectations."

I was thinking the same thing yesterday...

As regular readers know, we've been keeping close tabs on the yield curve as part of our "bottom is (probably) in" indicators... even though it's really more of an economic indicator than a stock market one.

But let me explain...

This year, the yield curve has told us enough about the economy and the stock market.

First off, when we say "yield curve," we mean a look at the yields of Treasury bills, notes, and bonds over a variety of durations, from one-month bills to 30-year bonds. Each has its own yield. When you look at them all together, that's the "curve"...

In "good" or "regular" economic times, longer-term yields are higher than shorter-term yields... This makes sense because you would want a higher return on your money for locking it up in a government bond for a longer period of time.

This means the yield curve typically goes higher and to the right the farther out in time you go, like a stock on a bullish run. As we shared last month via Pete Carmasino of our corporate affiliate Chaikin Analytics...

Here's what the yield curve across the spectrum of U.S. Treasurys looked like back [in January]. It's considered "normal" – meaning the longer-maturity end of the curve offers higher yields...

Other times, parts of the curve are "flat" or are in the process of "flattening," which can tell you something too about changing expectations in the $37 trillion U.S. bond market. This was happening in December and January, right before stocks peaked for good.

And other times, like today and for the past several months, the curve is bent well out of its typical shape – meaning shorter-term yields go higher than longer-term – or the curve "inverts."

This is the equivalent of the bond market saying, "Let's worry about what happens in the next year or two more than 30 years from now." With inflation what it is, and interest rates destined to stay at least above 4% for the foreseeable future, investors have on balance demanded a higher yield for these short-term cash-like vehicles. This is what we see now...

From here, we can also identify various combinations of yield comparisons like 30-year/10-year, or 10-year/3-month, which notably inverted just last month and whose spread is already down to negative 0.65 percentage points.

A good benchmark that we like to follow is the 10-year/2-year Treasury spread. As you can see from the negative reading on the chart below, it's inverted, too...

Two-year yields went higher than 10-year yields briefly in late March, then started a four-month run of the same behavior in early July. And as our subscriber Matthew pointed out, the "10-2" keeps growing more deeply negative.

Yesterday, the spread hit a new low at negative 0.68 percentage points. The reason is that expected inflation and interest rates have kept short-term yields high at the same time 10-year yields have dipped.

The decline follows expectations that the Fed might already be close to its maximum target benchmark rate for the interest-rate hiking cycle, thus easing demand for longer-term Treasurys. Remember, yields trade inversely to prices.

In other words, short-term interest rate (and inflation) expectations remain what they are. Any guesses past a year or two are more unclear, but for now, the market is betting on better times later rather than sooner. So, the "10-2" spread has widened to the downside...

Not since 1981...

Regardless of the why or if that happens, a bigger point to note is the 10-2 spread hasn't been this negative and trending down since ahead of the recession of 1981 and 1982. That's the one former Fed Chair Paul Volcker triggered with a federal-funds rate hike to near 20% in late 1980.

And before that, the 10-2 spread wasn't this low since 1978 and 1979, shortly after Volcker took over as Fed chair and began raising rates north of 10% to fight inflation. In fact, the scale and path of yields in '78 today look nearly identical to today. Not great company...

At the time, the '81 and '82 recession was the worst economic downturn for the U.S. since the Great Depression. Unemployment hit 11% and rates stayed high to fight persistently high inflation. According to a history of the Fed, written by the bank's Richmond branch...

As the [1981 and 1982] recession worsened, Volcker faced repeated calls from Congress to loosen monetary policy, but he maintained that failing to bring down long-run inflation expectations now would result in "more serious economic circumstances over a much longer period of time."

The "long-run inflation expectations" he was referring to included the 10-year Treasury yield, which ran up to 15% even after the Fed's benchmark rate went to 20%. We're not in that territory yet, but the story and quotes from the past Fed chair and current one, Jerome Powell, sure sound familiar.

And the trajectory of interest rates is the same. We're just starting from a lower level of near 0% instead of a local low of 5% in 1977, then around 10% in 1979. Different numbers, same narrative.

This same history does have some good news, though. While the bond market is signaling recession ahead, the worst for stocks may have already occurred...

Adjusted for inflation, the S&P 500 Index lost about 33% from a late 1980 peak to its July 1982 low near the end of the recession. Then it finished with a 15% return in '82 and had positive annual returns for the next seven years after this period.

I'm not saying this scenario is our future, but it's what happened last time. Until very recently, stocks had been down about 20%, suggesting some more downside ahead but perhaps that the worst of the losses have happened.

There is also this important nugget...

In past instances when the yield curve has inverted, typically stocks have peaked after the inversion. But not this year. Stocks peaked before the curve inverted for the first time since 1973, the last time inflation was as high as it has been recently.

We wrote more about this last month, suggesting most stocks wouldn't really bottom until the yield curve started to revert.

So what the heck does this mean?...

In practical terms, the inversion in the bond market means investors could get more government-backed yield from a two-year investment than a 10-year one.

In what world does that make sense? One with changing expectations.

Incidentally, you could consider taking advantage of the higher yields like 4.6% on a six-month T-bill to grow your cash if it's sitting around doing nothing.

And at the same time, the longer end of the curve has been reverting to normal a little. Today, a 30-year bond yields more (3.89%) than a 10-year (3.7%). That part of the yield curve is no longer inverted, albeit by a small margin.

So what is going on?

To me, this signals market expectations for higher inflation and interest rates in the next two years than they've been for the past 15 years, along with slowing economic growth.

In other words, it signals a recession – or at the very least stagflation if no one wants to call it an official recession. And, yes, this behavior seems unlikely to change until the markets strongly believe that interest rates will stop rising.

Now, this might sound bad, but it doesn't have to be...

If you adjust your expectations to the environment, you can still make money...

First, consider what our friend Marc Chaikin, founder of Chaikin Analytics, explains in his new prediction for 2023. Marc notes that certain stocks tend to take off out of irregular market bottoms like we might be seeing today... creating great short-term buying opportunities.

And I don't doubt that high-quality businesses that generate gobs of free cash flow will keep benefiting shareholders over the long run. Some industries, like insurance and health care, will even benefit from inflation and higher interest rates.

A higher-rate era can be a really great opportunity to find and own stocks of great businesses that provide value or in-demand services or products. It's the same for businesses that are able to consistently grow in a tougher growth environment.

It's a great time to get to work... as opposed to purely speculating on tech or unproven growth names in a 0% interest world, then basking in "bull market genius" status.

This is an opportunity to really separate yourself from other folks with money in the markets who aren't paying attention to what's really going on.

To this point, let's get back to boring old Treasury yields to round out our discussion today...

Treasury yields reflect a lot of important factors about the economy...

They tell us about growth expectations, inflation, and risk appetite. And they also reflect Federal Reserve manipulation, as the Fed – unfortunately – is a huge buyer and owner of Treasurys.

As our colleague Dan Ferris has said, the 10-year Treasury has been the "most important price in the world," but it has been increasingly manipulated by Fed printing and buying since the great financial crisis.

In the July 29 Digest, Dan wrote...

The Fed currently holds about $8.4 trillion in U.S. Treasury securities, mortgage-backed securities, and debt of various agencies (including Fannie Mae and Freddie Mac). The combined outstanding total of all three of those markets is about $37 trillion, according to the Securities Industry and Financial Markets Association.

That means the Fed owns about 23% of a $37 trillion U.S. bond market.

I promise if you buy 23% of a company, market, or anything else... you could push the prices around quite a bit. You couldn't do it forever because nobody can get permanent control of a $37 trillion market. But you could wreak plenty of havoc in a short period.

I looked today at the Fed's latest balance-sheet disclosure...

For all the talk about trimming its balance sheet this year, it still owns about $8.1 trillion of U.S. Treasury securities, mortgage-backed securities, and other debt.

The biggest allocations are $2.6 trillion of mortgage-backed securities of 10 years or longer, $1.4 trillion of U.S. Treasurys of the same duration, $2.6 trillion of reverse "repo" agreements with banks (a big story itself)... and $1.9 trillion of one- to five-year U.S. Treasurys.

(The Fed disclosures list assets by slightly transparent durations, like one to five years and more than 10 years. However, it's not narrow enough to show how many two-year or 30-year Treasurys, for example.)

Now, this says two important things...

1. The Fed is intimately involved in the Treasury market.
2. Short-term yields would likely be even higher than longer-term yields if the Fed didn't own so many shorter-term Treasurys.

Since yields trade inversely to prices, the fact that the Fed is a huge buyer of Treasurys ($5.6 trillion overall) puts a bottom under their value and keeps yields lower than they would be otherwise.

But the point is, despite Fed involvement, the shorter end of the curve is still "growing negative." In other words, the bond market keeps saying one thing, and the stock market another. For now.

Just today, debate has cropped up in the market once again about where rates will go from here...

Different Fed officials are saying different things again. As our Stansberry NewsWire editor C. Scott Garliss wrote this morning in his daily market preview...

Federal Reserve Bank of San Francisco President Mary Daly said a range of 4.75% to 5.25% is a reasonable expectation for peak interest rates, implying the current cycle is close to done.

Yet at the same time, another Fed member seemed to say higher rates could be warranted regardless of what happens to the stock market...

Federal Reserve Bank of New York President John Williams said monetary policy should continue to focus on economic stability and not financial-market stress.

And then Scott sent us this story today from Bloomberg...

Federal Reserve Bank of St. Louis President James Bullard urged policymakers to raise interest rates further, saying the level will need to be higher to meet the central bank's goal to be "sufficiently restrictive" to bring down inflation.

"Even under these generous assumptions, the policy rate is not yet in a zone that may be considered sufficiently restrictive," Bullard said Thursday in Louisville, Kentucky at an event hosted by Greater Louisville Inc. "To attain a sufficiently restrictive level, the policy rate will need to be increased further."

Bullard presented charts showing a sufficiently restrictive rate might be between about 5% and 7%, though he didn't spell out in his prepared remarks what rate level he favored.

If the Fed members indicate these sorts of expectations on paper at their next meeting in early December – when they are next scheduled to publish official quarterly projections – stocks could react like they did in September (down) when the Fed said the same thing...

Higher rates for longer, folks! Deal with it.

Alongside these comments today, the dollar rose a bit again, and major U.S. indexes took another breather from their recent rally as they approach a "bear mountain peak," as our colleague and DailyWealth Trader editor Chris Igou wrote today. Proceed with caution.

Facebook Whistleblower Says TikTok Will Be Worse

Frances Haugen, data scientist and Facebook whistleblower, recently sat down with our Daniela Cambone. She discussed her experience at the social media website... and why the influence of rival service TikTok is potentially more dangerous than what we've already seen...

Click here to watch this episode of the Daniela Cambone Show right now. And to catch all of Matt's shows and more videos and podcasts from the Stansberry Research team, be sure to visit our Stansberry Investor platform anytime.

New 52-week highs (as of 11/16/22): Biogen (BIIB).

In today's mailbag, feedback on yesterday's Digest and discussion about the dollar... and a thank-you note... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Good input, but this AM Bullard says we have NOT raised trades to restrictive enough. His new target is 5 to 7 percent. SEVEN PERCENT!

"Do you remember when the Fed actually said they were stimulating the stock market to increase liquidity?

"Me? I don't think the Dollar is as good an 'indicator' as markets seem to want it to be. I think it is like rat raises, it is a 'tool.' I think the Fed is targeting equity and bond prices... with a limit of employment (or actually unemployment).

"I agree. Chaikin's methodology is good. Historically (in aggregate) he is early to the table, which I suppose is why he is giving 'advance' warning this time. But I think the Fed's real target is stock price liquidity (a reverse of that old directive... or... 'a target that cannot be named').

"Thanks, good stuff." – Stansberry Alliance member Bill B.

"You guys [have] saved my business from misery. I cut my debt level to very low level and even got trophy real estate asset[s]. Thanx guys." – Paid-up subscriber Fredrik H.

All the best,

Corey McLaughlin
Baltimore, Maryland
November 17, 2022