You should be afraid

Worrying about the yield curve has become popular again in the financial press. My inner contrarian would usually find that incredibly bullish. However, in our judgement, the typical response from most analysts is to summarily dismiss the signal from the bond market. As I noted in November last year("the flood is the fault of the rain"), the persistent flattening of the curve is genuinely troublesome for future growth, profits and equity prices. The recent underperformance of financial stocks, despite robust first-quarter profits, may also be a reflection of the flatter curve. The big picture point is that no major inversion of the curve has ended well. More prosaically, inverted yield curves occur when monetary policy is tight. The Federal Reserve has explicitly signalled that they anticipate policy to be restrictive in 2020. However, there are a couple of subtle, but important points to note from a timing or tactical perspective.

First, while the yield curve has an excellent historical track record at major inflection points, it tends to lead the business and profit cycle by around two years. The lead is long and variable. Second, and perhaps more important is the fact that the curve must invert for a valid signal. During the 1994 tightening cycle the curve flattened sharply, but growth remained firm and the curve never inverted until the end of the business cycle five years later. Clearly, the flattening of the yield curve in that episode occurred years in advance of the 2001 recession. Nonetheless, once the curve moved negative and policy was restrictive the US economy experienced a business and profit recession. The large correction in equity prices also reflected extreme overvaluation in 2000 and a divergence between earnings and price well in advance of the bear market. Inversion of the curve in 2006-2007 was a valid signal.

The final point to note is that policy in this cycle is clearly complicated by unconventional measures including the asset purchase programs by central banks. Nonetheless, the flattening of the curve and the signal by the Federal Reserve on policy accommodation over the coming years is probably still valid. That US Total debt, primarily driven by an increase in corporate and public debt, and investor leverage is at a new record high suggests that the level at which policy becomes restrictive may be much lower level relative to history. It is plausible that another 50-75 basis points on the funds' rate might take policy to a restrictive level.

For markets, as we noted last year, that will coincide with liquidity withdrawal and a negative feedback loop similar, but more extreme than we experienced in the first quarter. Central banks have not eliminated the business cycle. Rather, by encouraging a long phase of stability through extreme liquidity provision, they have propelled leverage to a new record level and set up asset prices for an even greater phase of instability. The nature of the market or the regime has already changed. The price action is no longer a steady, low volatility uptrend, but a much broader range. Tactically we are bullish equities in the near term, but over the coming quarters, you should be afraid, very afraid.