09 April 2019
By Alex Karidis
If you’ve been listening to the news lately, particularly the financial media, you’ve likely heard the “R” word getting thrown around. What has triggered this has been a myriad of items, such as the 2018 Q4 stock market correction/bear market, slowing global economic growth, trade concerns, political hang-ups, such as Brexit, central banks becoming more dovish, despite only a few months ago, several announced their intentions to “normalize” interest rates, 2019 Q1 earnings and guidance upon us, and while there are several other reasons, the one that has gripped the most attention as of late has been the inverted yield curve.
Don’t let the name intimidate you, this simply means that shorter-term Treasuries are yielding more than longer-term Treasuries. In this instance, the markets are most concerned with the difference between the 10-year and 3-month Treasuries. Typically, longer-term durations will offer higher yields in order to compensate the investor/creditor for the increased risk(s) of sending his money away for 10 years as opposed to 3 months. This makes intuitive sense as interest rates or yields provide the markets with information and in this instance, a yield curve inversion is noteworthy because this does not happen often.
Inversion translates into a negative value (ex. 10-year minus 3-month, 2.4 – 2.55 = -0.15%). For this phenomenon to occur, a couple of activities or a combination thereof must occur. Recall that interest rates provide us with information, so if shorter-term notes are offering higher yields than their longer-term counterparts then markets are telling us that they see greater near-term risks. As such, in order to be compensated for this increase in risk, the investor/creditor requires a higher pay-off. Another way of looking at it, since bond prices and yields are inversely related, would be to say that there is an increase in demand for longer-term notes and less demand for shorter-term notes. So, an increase in 10-year bond purchases and an increase in the selling of 3-month notes. Again, the reason why this does not occur frequently is because in most situations, markets are more concerned with longer-term risks relative to near-term risks and thus we typically witness a positive yield curve. It’s easier to predict overall market conditions a few months to one year from now as opposed to 10 years out, makes sense, right? So, when we witness a yield curve inversion, we must pay attention. This is because the markets are signaling that near-term risks outweigh the longer-term, which may very well imply that a recession is on the horizon.
In fact, if we look at the data, an inverted yield curve has proven to be a very reliable leading indicator of future recessions. If you follow The Kapital News Podcast, you know well how we speak about the “economic puzzle” and how it’s our job to put the pieces together. Now while one individual piece does not paint the entire picture, the yield curve is a central element. Listening to the mainstream media, many pundits and analysts will tell you that the yield curve is “archaic” and that “this time is different.” When you hear these comments, especially the latter, you must know that this time is never different. It is wishful thinking that a recession is not on the horizon and that markets are fine and if the stock market is in a bull-market run, then it will continue. Just like the college frat-boy never wants the party to end, so too is the thinking of many market participants and analysts. However, all parties come to an end, and believe us, this time ain’t different! In fact, what lies ahead may prove to be the worse correction we’ve seen in a very long time, if ever. This is not said to frighten you, but rather for the purpose of providing information and preparation. The Kapital News is not a “perma-bear” news outlet nor a “doom and gloomer.” Rather, we provide our honest analysis wherever the data may lead. This segues nicely into the topic of this article – Why Do We Fear Recessions?
We find this to be a timely discussion and a well-placed question. While the word recession may invite several emotional responses, we must remember that the word correction is synonymous with recession. Therefore, why should we fear a correction? Aren’t corrections supposed to be good things? This applies to virtually all things in life. Imagine the following examples, recall when you were a child and you were learning to play an instrument or a sport. Clearly from the beginning, (unless you’re a prodigy), you stumbled along the way and probably quite frequently as you learned the fundamentals of the instrument or sport. Yet, as you made those errors, you were most likely corrected by an instructor, a coach, or your parents in order to help you get better. In fact, another way of looking at those errors is not as errors, but rather as learning experiences. It’s just as important to know what to do as it is to know what not to do. Now while we may become irritated and frustrated during our journey and may even seriously contemplate quitting the world of music or this new game, these emotions are no true reason to call it a-quits. And most definitely not a reason to fear the saxophone or a baseball glove.
In the world of music, no one sounded like Louis Armstrong the first time they picked up the trumpet. Likewise, no one hit the ball like Babe Ruth the first time they swung a baseball bat. Now consider the fact that neither of these titans of their respective industries were great on their first try either. It took time. It took patience. It took perseverance. It took humbling mistake after humbling mistake. And with it, yes, it took correction. Even to this day we admire the musical and entertaining talent of Louis Armstrong and still compare baseball statistics to Babe Ruth. For those of us who love music and sports, can you imagine a world without these two men and their contributions to their fields? They like all of us had their struggles, but they never gave up and never gave in to their frustrations. Instead, they corrected themselves and the worlds of music and baseball are eternally thankful. Expand this example to the fields of science and mathematics and the contributions of Newton and Einstein. Pick a field, any field, and the same story holds true. Why then would the financial markets and economies be any different?
The answer is, they’re not! What becomes of greater concern are the social and political risks that are likely to result from a recession. Just like Louis Armstrong, first-time entrepreneurs to the most seasoned of business executives will make mistakes. We are after all, human. From these mistakes, entrepreneurs and business executives hopefully learn and correct themselves and their organizations – thus making them better. However, there are times throughout history where some mistakes are just too big, and companies enter bankruptcy or simply close the doors for good. While people losing jobs is not a good thing, especially in the short-term, it will allow for the most effective and efficient allocation of resources – primarily that of capital and labor.
Ask yourself a simple question, if someone is a bad business manager, why would you want him to remain in business as a decision-maker? Perhaps he would be better suited in a different position. Even with time, he may become a great manager, but at this time, he is not. If we are to truly exist within a free-market capitalistic system, then failure is the greatest regulator, it may also be a great teacher. It happens to be an assortment of failures occurring in harmony that creates a recession. These failures occur for several reasons, but they can be attributed to business managers in some sense. They made the wrong decisions. They took too big of a risk or too many risks and they did not pay out well. We may applaud the risk-taking, but we must also criticize and learn from the mistakes.
The markets are concerned with goods and services being produced as efficiently and effectively as possible. And remember, markets can only produce what the markets want – otherwise somebody is going out of business. The producer wants to increase productivity, reduce costs, and beat their competitors on price, quality, options, etc. The consumer wants options, quality, and lower prices. Therefore, everything appears to be in agreement. However, when a recession occurs, those who are not operating under best-practices will suffer and perhaps go out of business. Again, not great for those immediately affected. However, the market is made better off because, in theory, those who remain are the best performers, and markets always look for and reward the best practitioners. Thus, markets are improved upon.
In a recession, people are concerned with losing their jobs – understandable. However, politicians, central bankers, and business leaders are concerned with being blamed – poor leadership. While this article could continue at length on the many faults that exist within our government, our central bank, and many of our crony-corporations, we will save this analysis for another time. Suffice to say, that those institutions are ripe to be blamed, yet we the people should not fear recessions, as we are made better consequently. Might it be painful and frustrating? – yes. But we’re not in first grade anymore. We don’t get stickers of stars on the wall and lollipops just for showing up. We need to get better in all that we do and to learn from our mistakes and to correct ourselves and to help each other. We must look at recessions, not as a problem unto itself, but rather as an opportunity to correct ourselves as individuals, as citizens and taxpayers, as employees and employers, as governments, as businesses, and on the other side, we’ll be that much better. We should be more concerned with how governments and central banks (typically the primary cause of recessions), come in to “save the day.” They caused the problem and we can assure you that they do not have the solutions. It’s as if they broke our legs and we’re supposed to thank them because they gave us a pair of crutches.
We should not fear failure. We should not fear getting better. We should not fear correcting ourselves and our institutions. We should not fear success. And we should not fear recessions.