Counting the Discounting

Today the 5 year bond yield fell below the 2 year bond yield

Written December 4th, 2018

ALLEN GILLESPIE, CFA® 

Today the 5 year bond yield fell below the 2 year bond yield.  The “inverted yield curve” certainly spooked stock investors, as stocks fell over 3%, because people know the yield curve has historically “inverted” prior to recessions, but is selling now the right thing to do?

One of the reasons markets are confusing to people is our language.  Since the market is about numbers, one of the things we are supposed to do is count, but then accountants teach us to discount the numbers.  Webster defines “discount” as follows:

  1. to deduct a certain amount from a bill, charge, etc.
  2. to offer for sale at a reduced price
  3. to allow for exaggeration
  4. to take into account in advance, often so as to diminish the effect of

Since investment markets are a discounting mechanism, when people are discussing the 5 year bond yield, they are discussing the average interest rate the market expects to exist over the next five years.  As a lot can happen over a five year period, it is not surprising that a quick study determined the following:

  1. Yield curve inversions do tend to lead recessions and poor stock markets, but the lead and lag times vary, as the market is basically saying somewhere between 2 years from today and 5 years from today we expect lower interest rates.  In fact, using data from the Federal Reserve since 1976 we found there have been 79 months during which the 5 year yield was below the 2 year yield.  During those months, the stock market was up 52 times (65.8%)  and down 27 times (34.2%) and had an average return of 54bps a month v. 58 bps per month return on average for all months.  In short, the math suggests it does not pay to sell stocks during a yield curve inversion.
  2. However, this is typical in the data.  The yield curve on the 5/2 spread was inverted from Dec 2005 to May 2007, a decent time for stocks, but then turned positive from May 2007 through the 2008 period, a bad time for stocks, because the bond market was trading two years forward.
  3. In conclusion, the yield curve’s shape is a leading indicator, not a coincident indicator. Therefore, we should remember which direction it is pointing, but acting today on the information is to misread the signal.

 

The key to markets is not to invest based on what you see today, but invest on what you expect sometime in the future.  If equity markets are selling off due to the 5/2 spread, then history would suggest that smart investors might be receiving an opportunity to purchase discounted securities at exaggerated prices from people who haven’t done the math.  The rub is you might want to sell them sometime in the next two years.

 

*Special Note on the Political Wild Card* – Two bits of market political history.  Ned Davis reports that after a Republican President loses the House, then the US stock market is largely flat over the next twelve months.  If the Democratic House moves to impeach in January, then the event trading computers may go into “Richard Nixon” resignation programs, which was a brutal 23% correction in two months before a new two year bull market started.

The big takeaways for investors are that it is never a bad time to consider and reconsider the timeframe of goals, objectives, investment time horizons, risk tolerances, and diversification strategies.

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