The Bond Market Does Not See Quick Recovery — In Fact It Sees the Opposite

By: Justice Clark Litle

May 12, 2020 | Educational

There is no V-shaped economic recovery. We won’t see a U-shape, either.

Instead, there is greater likelihood America’s recovery will have an L-shape — a flat crawl after a hard drop. And that’s only if we’re fortunate, and do a better job in the virus fight.

If we get the next part wrong, America could wind up looking like Europe or Japan, with a descent into negative interest rates. And if we really get it wrong, we’ll face a second Great Depression.

That is the bond market’s view, not just our view. The U.S. Treasury bond market has a very different message than the U.S. stock market right now (which was a lousy messenger, anyway).

The major U.S. stock indexes seem to be saying: “No really, everything will be fine! Who are you going to believe, us or your own eyes?”

Whereas the bond market is saying: “Your eyesight is just fine. The economic carnage you see, and quite possibly feel yourself — through friends, relatives, or your own small business — is real. It’s going to take a while to dig out of this.”

First we’ll explain why the bond market looks so bearish. Then we’ll explain why the stock market, as a recovery barometer, is entirely unreliable and should not be trusted.

The bond market is deeply bearish on two fronts. The first one is the two-year U.S. Treasury yield.

On Feb. 24, just after the S&P 500 topped out, the two-year U.S. Treasury yield was 1.36%. As the market crashed, that yield plummeted toward zero — and it hasn’t bounced back. As of this writing, the two-year Treasury yield is 0.16%.

The long-term average for the two-year Treasury yield, according to data provider Y-Charts, is 3.32%.

This means that, even before the February-March market crash and pandemic-related shutdowns, the two-year yield was less than half its long-term average. That is a sign of economic weakness. When yields are low, borrowing demand is weak, which means economic vigor is lacking.

There is no economic vigor at all in a two-year yield near zero.

If hopes for a V-shaped recovery were grounded in reality, instead of wishful thinking, the two-year yield would be higher, reflecting a rising demand for capital and greater circulation of economic activity in the lifeblood of the U.S. economy. 

The bond market’s second message is even grimmer. The Fed funds forward curve is forecasting negative U.S. interest rates starting in summer 2021.

Federal funds futures, commonly known as “Fed funds futures,” are a marketplace for anticipating the future direction of interest rates.

Commercial players use Fed funds futures to “hedge” their exposure to future interest rate decisions of the Federal Reserve, in the same way crude oil futures are used to hedge crude oil exposure, soybean futures are used to hedge soybean exposure, and so on.

In a past TradeSmith Daily we explained the bearish message of the crude oil forward curve. Via the back months of the Fed funds futures market, there is also a Fed funds forward curve — with expirations stretching years into the future — and right now that curve sees the Fed going negative by June 2021.

Think about that for a moment. Even as the stock market indulges the optimists with a shiny, happy interlude, the Federal Reserve — as anticipated by the Fed funds forward curve — is expected to go below zero in about a years’ time, joining Europe and Japan in the land of negative rates.

Federal Reserve Chairman Jay Powell is adamant this will not happen, of course. But that is the only stance he can take. For the Fed to admit that “yes, negative rates are on the horizon” would be tantamount to forecasting economic doom, or admitting outright that America is becoming like Japan.

“I am surprised to see some of these expectations for negative rates so soon after the Fed has done so much,” government debt trader Larry Milstein told Bloomberg. “I would have thought that the market would wait to see how this all plays out,” he added, “yet some investors think the Fed doesn’t have many more levers left.”

We’re not surprised at all, quite frankly, because lending is not spending — the Fed can lend like crazy, but it can’t make consumers spend a dime — and furthermore, because the idea that a few trillion dollars in stimulus would fix everything, as large as that amount sounds, was always naive.

Part of the problem is that people hear about a multi-trillion dollar stimulus and they think about it in a vacuum. Their eyes get big at the sheer size of the bazooka. Whoa, wow, trillions of dollars, that’s a lot!

Not today it isn’t. It is not a lot because one has to ask, “a couple trillion dollars in comparison to what?”

  • Is a few trillion dollars “a lot” in comparison to, say, somewhere between 12 million and 15 million small businesses going under?
  • Is it a lot relative to Great Depression levels of unemployment — authorities are already admitting we are headed above 20%, and that is just the official number — for a $21 trillion economy?
  • Is it a lot for an economy that used to be 70% driven by consumer spending, and that is now seeing consumers slam on the brakes, with no telling when their psychology or their battered pocketbooks will mean-revert?

Here is another statistic to make you think: The most recent data point for the monthly change in U.S. consumer revolving debt levels was negative $28.176 billion.

What that more or less means is that, across all the credit cards and home equity lines of credit, all across the land, Americans lowered their collective balance by more than $28 billion.

The normal pattern over the past few decades has been to see that revolving balance rise every month, not fall — with very rare exceptions — to the tune of single-digit billions. 

So a print of “negative $28.176 billion” is another one of those huge, cartoonishly freakish “never before in history” type data points, where the decades-long chart appears as if an anvil was dropped from the top of a building, into a mineshaft, and then continued falling deep into the earth.

But of course that huge drop in consumer debt balances makes perfect sense, because look, of course consumers are saving like crazy and slamming the brakes on spending with unemployment levels expected to crack 20% (and probably already there).

Why wouldn’t sane Americans holding too much credit debt (which is a huge percentage of them) use their emergency stimulus check to pay off a chunk of that debt, if they can, as they hunker down to face an economic storm the likes of which we’ve never seen before?

When the government and the Fed sprays money at consumers and they take that money and pay down debt with it or shove the money in a mattress for the hard times ahead, the monetary velocity of those stimulus funds is zero. The new funds are consumed by debt loads and a savings gap, like matter eaten up by anti-matter.

To us it seems clear: The two-year yield is hugging zero, and the Fed funds futures market is forecasting negative rates by summer 2021, because America and the world are living through the most deflationary event in 90 years, and the impact of that event (with the worst fallout still to come) is just now beginning to be felt.

Think about what happens when bold, brash, free-spending, debt-loving Americans — the all-time champion consumer spenders — become cautious, worried savers, afraid to take social risks and newly keen on paying down debt. Because that is what is happening now, right before our eyes.

That sea of change, if it plays out as we think it could, could be so deflationary, in terms of real economic activity impact, that it makes a few trillion bucks in stimulus look like a nickel pitched into a beggar’s cup. 

So, what about the stock market then?

Has the stock market, as bullish as the day is long in the face of all this carnage — with the dangers of a pandemic on top — just completely lost its mind?

Nope. Not necessarily. The first thing to note is that the stock market is a terrible barometer of the actual U.S. economy. It represents a different thing.

In some ways, substituting “the market” for “the economy” is not just apples to oranges; it is more like apples to Pontiacs or apples to ninjas.

For example: Take the “big five” tech juggernauts: Apple, Amazon, Alphabet (Google), Microsoft, and Facebook. These five companies account for 20% of the S&P 500, according to the Wall Street Journal. By other estimates, the tech juggernauts account for a whopping 40% of the Nasdaq.

So a huge percentage of stock market performance is due to technology winners. And after the juggernauts, you have another tier of winners like Zoom and Netflix, and biotech winners like Gilead, and a whole host of other companies expected to win in the post-pandemic future.

Some of these — like Amazon in particular, which we are long in TradeSmith Decoder — can do well even in a full-blown Great Depression.

There were companies and industries that saw astronomical gains in the first Great Depression, and if we wind up in another one, it will happen again. (For Amazon in particular, the company’s suite of competitive advantages is so strong, it is valued more highly than a “fortress balance sheet” — one that is unquestionably strong — and so the company is treated as a safe haven.)

So, to some degree, the stock market is reflecting a “winner-take-all” post-pandemic landscape by accruing ever more value to a selective circle of winners, and those winners are pumping up the major U.S. indexes.

But the indexes are not reflective of the total economic outlook, or the recovery picture for the average American or the country on the whole. Great swathes of the U.S. economy look like wreckage, and this is true for the market, too. You just don’t see it reflected in the Dow Jones Industrial Average and the S&P 500.

The stock market may no longer care about energy companies, for example — whose representative performance share is down to single-digit percentages — but Texas sure does.

Then, too, the stock market has plenty of manufactured enthusiasm priced in because, for the vast majority of long-only money manager professionals who pick stocks for a job, something known as “career risk” dominates their thinking.

Career risk logic goes something like this:

“If I am wrong and the market goes down, but everyone else loses too, I’m OK. But if I am wrong when the market goes up, and my colleagues are long and I’m not, I get fired.”

That is the way the majority of long-only money managers think. And, all these money managers remember what happened in 2018. In December 2018, the market went into full meltdown; the Dow had its single worst month in 70 years.

But then the Federal Reserve had a miraculous change of tune, and the market snapped back. From January 2019 onward the market proceeded to go straight up, as if December had never happened.

Long-only money managers remember December 2018, and they are terrified of being left behind if the market does that again. If the February-March drop is a replay of the December 2018 drop, and they don’t buy as the market soars away from them, they risk getting fired.

So they chase, and they buy as much out of fear (for their own jobs) as out of hope, and then they make up reasons for being bullish and fill in the blanks afterward.

The trouble is that, though being long is a one-sided bet for the average money manager, it is very much a two-sided risk for actual investors. If an investor is long and wrong in a big way, they can’t just shrug it off. Their whole retirement is at risk. 

Finally, with regard to the stock market: Remember that, when a real bear market begins, ripping bear market rallies — which falsely appear to be “the bottom” — are a normal occurrence. Consider this sequence of events:

  • March 10, 2000 — Nasdaq 100 peaks at 5,048.62.
  • May 25, 2000 — Nasdaq 100 closes at 3,099.28.
  • June 19, 2000 —Nasdaq 100 closes at 3933.70.
  • October, 2002 — Nasdaq 100 trades at 849.57.

After the Nasdaq topped in 2000, it took less than three months to decline nearly 39%. The following bear market rally, of nearly 27%, happened in less than four weeks.

And then the bottom fell out. After two-plus grueling years, a decline of more than 77%.

Lessons? Listen to the bond market, not the stock market. Be aware that yes, the bond market is absolutely confirming the economic carnage that you see, and it is doing so with a vengeance. As for the stock market, bear market rallies should be rented, not bought, even when there is strong temptation to believe a new bull has begun.

A forecast for negative rates in 2021, coupled with near-zero two-year-yields and U.S. consumers saving like never before, confirms we are facing anything from a severe recession to a Great Depression — and it will take both skill and luck to avoid the worst-case scenarios.

Last but not least, if you want to be long — and there are, indeed, very good things to be long — make sure you own the right stocks. Because if you own the wrong ones — like consumer-oriented blue chips dependent upon a recovery in consumer spending, for example — your retirement could be destroyed.


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