On Friday, Mar 22, 2019, the 10 year yield on US Treasury bonds went below the 3 month Yield Treasury bill.
To explain what a Treasury bond is, it is basically a debt instrument (aka loan) issued by the US Government. A 3 Month Treasury bill means that the debt matures in 3 months, likewise a 10 year bond means the debt matures in 10 years.
That actually sets the stage for this discussion. First, let me try to explain this in as simple as terms so that elderly people can understand.
The yield of a treasury bond really means what kind of returns investors are willing to receive to buy the bond. So in the example above, investors are willing to accept a return of 2.434% a year if they invest in a 10 year treasury bond as opposed to receiving an interest of 2.464% pro-rated over 3 months, if they invest in a Treasury bill. The difference is -0.032%
That actually is interesting. Why should someone be willing to accept a lower return for investing in 10 years, as opposed to investing over 3 months. For example, one could just keep on buying 3 months Treasury bills over 10 years – i.e. this means that every 3 months they keep on buying 3 months Treasury bills and do so for 10 years and be better off than just buying a 10 year bond?
The reason is that the yield on 3 months bill is extremely related to the Federal Reserve’s interest rates. That is the “big event” you hear about every other time – the Federal Reserve cuts interest rates or raises interest rates. (Technically it refers to the rates at which banks lend money to each other, but that is a topic for another day – like when we have bank failures, but for today lets believe it is the same). The idea is that if there is a recession, the Fed could cut rates to any number, even negative rates, like what happened in Europe. This means that those who had a locked in 10 year interest rate of 2.434% would do better than the poor fella who believed that 3 month rates would remain higher.
By the way, if long term rates do fall to 0, like the case in Germany, a 10 year Treasury bond with an interest rate of 2.4% which was previously traded at $100 will be worth $123. So that is a gain of 23%, which is massive for bond traders, who trade in the hundreds of millions, if not even billions at one go.
Actually, the last point deserves some mention. The daily trading volume of US Treasury bonds is about $600 billion dollars. To put it in context, the daily trading volume for Apple Computers, is about $6 billion dollars. To put this is another context, the total outstanding US Treasury debt is about $21.5 trillion dollars versus the total Dow Jones Market Capitalisation of about $6 trillion.
Ok, now why do people get so messed up about this?
The reason is that this Yield Curve inversion is one of the best leading predictors of a recession. Bond traders are driven by fundamental economic data and do not care how sexy your Amazon, your Apple or any other stock sounds at the moment. They are making the best possible decision using all the available information and not based on algorithmic driven momentum training. When the economic data worsens, they feel that a recession is around the corner and the Federal Reserve will cut interest rates to stimulate the economy. I will explain the last part a bit later. That is also around the time that all these sexy stocks we hear about get smashed down. Netflix is a good example of overlevered cash burning stock , soon to be joined by Lyft and Uber.
So why should a recession matter to the stock market?
Well, this is because a recession will cause the earnings of the Companies to plummet . Some , who have borrowed too much money, may even go bankrupt. The share prices tumble as investors face this bad news. Business investment collapses, so even the strong companies don’t earn as much. Also, the market reaction usually happens very quickly so investors may suddenly find themselves with massive losses within 6 -8 months, as what happened in 2008.
For example, take Micron – one of the leading producers of computer memory.
This is probably the best example of seeing how a recession can totally destroy the share price of a company. This is because Micron manufactures a commodity – computer memory, which is also manufactured by other South Korean companies. When there is a recession, the demand for computer memory may fall, causing all these companies to fight for the smaller demand and undercut each other. The end result – nobody makes any money and all die together. Likewise, when there is a boom, the demand is so great but only few people can supply the goods, so the companies make a lot of money and their share prices rise.
Ok, now back to the last point – why does the Federal Reserve cut interest rates when they are facing a recession?
The reason was because lower interest rates would make banks more willing to engage in riskier lending and so stimulate the economy. But this idea is total crap – as the EU has been in negative interest rate regime for a long time but economic growth was pathetic for the last 10 years. What lower interest rates do is to incentive the large companies to borrow big and buy back their stock. Imagine what happens if they borrowed all the money to buy back their stock at high prices and then the market collapses? Sounds dumb right – but that is a story for another time.
So lastly, is this yield curve inversion a big deal for stock market investors over the near term aka 1 – 2 weeks?
The answer depends on the computer programs that really drive the prices of securities, which in turn drive investor behavior. Literally, if the AI programs believe that people have become more cautious, they will drive prices lower, causing the market to go down. If the AI programs believe that big investors ignore this and are willing to buy up, prices will pop up rapdily. However, this chart is a bit scary. JP Morgan started the week at about $107 and ended up down below $100. The last time this happened, it was in December 2018, followed by a very sharp steep selloff. The AI computers may actually learn from that and start to sell off aggressively on Monday – that is my best guess.