The Die Is Cast

2019-10-10 | Sam Shames

Let’s talk about the yield curve.

What is it?

Yield curve is a visual representation of the “spread” or difference between government bonds of different maturities.

For example, if the 10yr bond has a rate of 2% and the 2yr bond has a rate of 1% that would mean the 10y/2y spread is 1%, or the difference between the two.

A positive number is historically the norm as longer maturity dates should pay more than shorter maturities given the additional risk for the additional time.

However, we are not seeing that currently. What we are seeing is an inverted yield curve where shorter-term government paper is yielding more than longer term.

For example, 10yr bond has a rate of 2% whereas 2yr bond has a rate of 3%, the difference between the two being negative 1%.

That is not normal, so what’s going on?

Simply put, the bond market is pricing in additional risk at the front end of the curve because they see immediate risk on the horizon.

Let’s take a look at a slice of the yield curve that visually shows this dynamic quite well, the 5yr/2yr spread.

The Die is Cast

A brief key to the chart: the lower range in yellow represents a negative value, or inversion, between these two maturities… the red circles show the periods in time where this inversion has previously occurred, the yellow vertical lines indicate “events” or moments in time where the talking heads on the news can point to and say “that’s why the market dropped.”

Let’s dive in reviewing each point.

First 1989-1990… this was during the oil crisis, savings & loan fiasco, and Fed raising rates which led to a recession. The response by Fed was to cut interest rates and we see a spike in the chart.

Next 2000-2001… dot com bubble + 9/11 was the “event.” The response by Fed was to cut interest rates and we see a spike in the chart.

Next 2006-2007… housing crisis + derivatives crash was the “event.” The response by Fed was to cut interest rates and we see a spike in the chart.

And now 2019-202X… the “event” is unknown at this time. The response by Fed will be to cut interest rates and we will see a spike in the chart.

So, what does it all mean?

Each time the yield curve is inverted historically it is like plaque buildup within the financial system… money is flowing but at a slower rate… this is the precursor.

Next, we have the “event” which traders and everyday people can look back upon and say, “that was the catalyst.” This is the equivalent of a financial heart attack after the plaque buildup phase.

Lastly, we have the “reaction” which every time is Fed lowering rates as a response to the event. This is the equivalent of being treated at hospital after the heart attack.

The point is that we have reached the historical point of no return. The die is cast for the next event and we don’t know what that will be, however, we do have the ability to see the plaque buildup in the system before it happens and we know what the reaction from Fed will be.

I show you this to better understand the historical significance of this particular moment in time.

We are still in a bull market based on price alone, the backdrop is no different than a person with plaque buildup in their arteries blissfully unaware and chomping on cheeseburgers until it’s too late.

The longer-term trade that develops from the dynamic of the yield curve further inverted is long bonds, long dollar, long gold, short banks, short small caps.

Every bull matures the same way…

Hope takes it higher, credit brings it down.