“You’re going to the moon…” FANGS! Technology and the FANGS (except for temporary bad dog Netflix) helped to rocket the S&P500 and NASDAQ 100 to impressive heights in yesterday's session. Here’s how it all went down. Industrial Production was up a tad more than expected: not big news. The President upset everyone… EVERYONE (except Russia): not big news. Netflix tanked but managed to rally into the close: interesting, hold that thought. Amazon had service outages during its Prime day, only the greatest day in the retail year for them behind Christmas, and traded up: also interesting. Fed Chair Jerome Powell gives Humphrey-Hawkins testimony on the Hill and says exactly what everyone expected and what I wrote in Monday’s note (trust me on this) and markets get the "Blue Horseshoe" code and trade straight up. The S&P500 has been constructive and has made a few closes above the magical 2800 level, the NASDAQ is making new highs almost daily with little in the way of even gravity holding it back, the Russell 2000 index was due for a buy-the-dip bounce (Blue Horseshoe loves small caps), and the industrials of the Dow have been freed up from trade rhetoric for a few days allowing it to attain some important closes. Ten year treasuries did not get the Blue Horseshoe code and yawned the day away but the two year notes got a different sort of message causing traders to fade the notes making their yields rise. And I would be remiss, if not boringly repetitive, if I didn’t mention that it caused the yield curve to flatten yet further to 24 basis points on the 2/10 swaps. You might ask: “Mark, what does that really mean?”
It really means that if you loan your money to the US Government for two years, they will pay you 2.62%. Great! If you loan them money for 10 years, they will only pay you another quarter of a percent more (actually a little less). That seems like a pretty bad deal for investors. The aforementioned is what it “really” means, that is it. But what about all of this talk about recession and a flat yield curve? Don’t worry if you find it confusing, the Senate banking committee was confused by it as well and Jay Powell’s explanation confused them even more. I’ll explain it right here once and for all. When traders expect a recession on the horizon they know that rates will eventually go lower as the Fed will ease rates to counter it. The traders will buy longer maturity treasuries hoping to make money. The buying causes an increase in demand, causing prices to go up and yields to come down. Today, the Fed is not focused on getting us out of a recession, but rather quite the opposite. They are trying to tame a hot economy in order to avoid inflation (1/2 of their duel mandate) by raising short term interest rates. Front end goes up, back end goes down, and we have a flattening yield curve. Buying the back and selling the front heats up just before a recession ultimately causing the yield curve to invert. The only thing that can reverse it and cause the curve to steepen is for the Fed to reverse its policy and begin to ease credit again. SO, a flattening and inverting yield curve typically precedes a recession… IT DOES NOT CAUSE ONE. Many economists believe that the curve will invert later this year or in the first quarter of 2019. The curve almost always inverts prior to a recession, but the time between the inversion and recession varies with each recession. Of course, nothing is ever clear. So as long as the economy continues to perform well, inflation remains within the target, unemployment remains low, and corporate earnings continue to remain strong there is no reason for markets not to continue to be constructive. The caveat however is that we need to watch things really closely because the first hint of weakness on any of these fronts could change the outlook rather quickly. Any money earmarked for events within 3 - 5 years (such as retirement) should be diversified now in order to avoid pain. So to sum it all up. A flattening yield curve does not cause or predict a recession. The dichotomy between what investors believe will happen and what the Fed must do today causes the curve to flatten. A recession will most certainly happen at some point in the future, exactly when is the big, yet still unanswered, question. One of these days, one of these days (that was another reference to the opening quote)! Please call me if you have any questions.