'This Time Is Different'... Or Is It?

Beware the most dangerous phrase in finance... 'This time is different'... Or is it?... Why some believe the major 'get out' signal may not be so bearish after all... These charts say the Fed is making a serious mistake...

A familiar refrain is making the rounds on Wall Street today...

"This time is different."

This may be the most dangerous phrase in all of finance. You often hear it toward the end of bull markets, when euphoria takes hold and folks become convinced that the "old rules" no longer apply.

For example, we heard it in the late '90s, when folks fell in love with Internet stocks. "This time is different," they said... Stocks weren't expensive, because profits were no longer important in the "new economy." The only things that mattered were "clicks and eyeballs."

We heard it again last decade to justify the massive bubble in the housing market. "They aren't making any more land," they said. "And home prices never go down."

Today, we're hearing similar comments in response to worries about the U.S. Treasury 'yield curve'...

As regular Digest readers know, the yield curve has been a powerful leading indicator for both stocks and the economy over the past several decades.

In short, whenever the yield curve has "inverted" – that is, when the spread between long-term and short-term interest rates has turned negative – bear markets and recessions have predictably followed several months later.

This is why both Porter and Steve Sjuggerud have called yield curve inversion a major "get out" warning for stocks.

As we've been tracking in the Digest, this spread has been falling rapidly over the past several months. We're now dangerously close to negative territory... which means the "countdown" to the end of the bull market could soon be underway.

But not everyone is concerned about the yield curve today...

A growing chorus of analysts and financial pundits believe "this time is different." They believe the rapidly flattening yield curve isn't really a warning sign this time around, due to something called "term premium." A Bloomberg report this morning sums up the general argument...

Alarms about the flattening Treasury yield curve are probably overblown, considering how much tamer a move there's been once risk premiums are stripped out...

At issue is the way that a depressed term premium – the extra compensation buyers usually demand to buy longer-term debt rather than rolling over short-term securities – is affecting longer-term yields. Fed Chair Jerome Powell himself has postulated that low long-term yields are due in part to historically unusual term premium, which is now negative.

Term premiums slumped across world markets in the wake of the financial crisis as the Fed and its peers mounted large-scale bond purchases through quantitative easing programs.

As the article noted, term premium is simply how much more yield investors demand to hold a long-term bond rather than a series of short-term bonds.

Usually, this premium has been positive. To use a simple example, this means the yield you would earn to hold a 10-year U.S. Treasury note to maturity has usually been greater than the total yield you would earn to hold one-year Treasury bills for 10 consecutive years.

But today that isn't the case. Thanks to the Fed's unprecedented stimulus programs, risk premium has gone negative. And this means long-term Treasury yields are lower than they otherwise would be.

In other words, the bullish argument is that today's flattening yield curve isn't what it seems...

It isn't a sign that the Federal Reserve is raising short-term interest rates too quickly, as has been the case in the past. Instead, it's the result of lower-than-usual long-term rates... which means inversion won't carry the same bearish message as it has in the past.

As we noted at the time, previous Fed Chair Janet Yellen made exactly that argument during one of her final press conferences last December. And indeed, it appears most Fed officials under current chair Jerome Powell continue to believe that today. As the Wall Street Journal reported earlier this week...

An inverted curve is a signal investors believe that the Fed's current rate-raising efforts are going beyond what the economy can handle and overnight rates will eventually fall. Fed policy makers don't seem to think that is the risk now.

Rather, they think longer-term yields are lower than they should be because of all the bonds purchased by the Fed and other central banks to prop up their economies...

According to New York Federal Reserve estimates, if the average term premia that prevailed over the past 25 years were in effect today, the 10-year Treasury yield would be about 1.4 percentage points higher than the two-year yield.

There's just one problem...

It's more or less the same argument they made the last time the yield curve inverted... an argument that was soon proven to be terribly flawed. More from the Journal...

In 2006, the Fed's view of the inverted yield curve was that a global saving glut had pushed down long-term interest rates. Meeting transcripts show policy makers believed this had driven down term premia, just as they see the glut of central bank holdings driving down term premia now. As a result, they weren't all that worried about the inverted yield curve. By the end of 2007 the economy had entered a recession and they were frantically cutting rates.

But this isn't the only reason to question the Fed's rosy outlook...

The following charts compare the Treasury yield spread with "spreads" in business and consumer sentiment. These spreads represent the difference in sentiment between current conditions and future expectations.

When these spreads are moving higher, it means businesses or consumers are optimistic about the future – that they expect future conditions to be better than the present. When they're moving lower, it means businesses or consumers are pessimistic about the future.

The first chart shows business sentiment, as measured by two widely followed indicators: the Empire State Manufacturing Survey (conducted by the Federal Reserve Bank of New York) and the Manufacturing Business Outlook Survey (conducted by the Federal Reserve Bank of Philadelphia)...

The next shows consumer sentiment, as measured by the Conference Board's Consumer Confidence Survey...

These charts are sending two clear messages today...

As you can see, both of these measures have been highly correlated with the Treasury yield spread over the past several decades.

And despite arguments to the contrary, they both suggest that the recent plunge in the yield curve should be taken as seriously as ever.

Once again, let us be clear...

This is not a reason to panic and sell all your stocks today.

The yield curve has not yet inverted, and it may not do so for some time. In addition, as Steve explained in yesterday's Digest, it isn't necessarily an immediate sell signal. In the past, the market hasn't peaked for an additional six to 18 months following these signals.

But when we finally do see inversion, we urge you to take it seriously. We certainly will.

New 52-week highs (as of 7/24/18): AllianceBernstein (AB), Becton Dickinson (BDX), Facebook (FB), Alphabet (GOOGL), ProShares Ultra Technology Fund (ROM), and Williams Partners (WPZ).

In today's mailbag: Kudos for "Kiz"... and another Stansberry's Credit Opportunities subscriber shares his experience buying bonds for the first time. As always, send your questions, comments, and complaints to feedback@stansberryresearch.com.

"Porter, just a quick note complimenting you on choosing to sponsor Kevin Kisner. He's a gritty competitor and I'm always excited to see him in contention and am rooting for him to break through in his first major. I'm sure you were bursting with pride to see the name and logo of the company you started at your kitchen table all those years ago on the screen in the final groups on the weekend at golf's oldest major. And, you should be. You and your team have done a great job and I appreciate all you do for us. Congratulations on your successes and here's to many more to come." – Paid-up Stansberry Alliance Member Henry D.

"I was skeptical at first and as a small time investor with under $6,000.00 dollars to invest I took a leap of faith and signed up for [Stansberry's] Credit Opportunities. Because I didn't have a lot of money to invest I could only buy your bond recommendations when they matched my price range and usually well below your "Buy up to" prices. Two of those situations came to fruition earlier this year with your Community Bank Bond and Monotronics recommendations, I am currently sitting on a 64% YTM and a 38% YTM respectively. I couldn't be more pleased with this service and the thing I like best is I don't have to keep trading in & out and the interest payments are the bomb?" – Paid-up subscriber R.S.

Regards,

Justin Brill
Baltimore, Maryland
July 25, 2018