I made a post before how an inversion of the yield curve has preceded the last 8 recessions in the US. Recently, I came across this interesting chart on Twitter which shows the yield curve spread for US treasuries with a maturity of 3 month and 10 year from the last 100 years.
This chart shows that yield curve inversions didn’t happen between the 1930’s and 1960’s before a recession happend.
Currently the US 3 month – 10 year yield curve is inverted.
Purchasing Managers’ Indexes (PMI) are economic indicators derived from monthly surveys of private sector companies. Today the latest PMI Manufacturing Index for the US (The ISM Manufacturing Index) came out which was the most negative reading in the last decade.
Global manufacturing PMI’s are rising again though after a record streak of 15 negative months of declines. The last time this index went positive after a long streak of negative PMI’s it was 2009 and that turned out to to be the bottom and a great moment to buy stocks.
The above index has coincided quite nicely with the Bloomberg World Stock Market Cap index which hit a high in January 2018. The index still hasn’t recovered since then.
An inverted yield curve is one of the few indicators that before have always correctly signalled an upcoming recession. An inverted yield curve happens when the yield on 10 year treasuries is below the yield on 2 year treasuries (sometimes called the “2s10s”). The 2-10 year yield curve is the most common people view. Currently the 2-10 year yield curve is positive after it turned negative for the first time since 2007 at the end of August.
In the past a negative yield curve has always signalled that a recession could happen in the next 1 to 2 years. Note from the chart below that the curve can be at or below zero for a long period before a recession happens. Furthermore from the chart it looks like a rapidly steeping yield curve signals a recession is close.
The question arises will an inverted yield curve signal a recession this time? A big difference in my opinion with other times is that this time the yield curve is watched by a lot of participants in the market and so a lot of stories are published about it.
From the mainstream media such as Drudge Report.
To the president of The United States who even talks about a “crazy” inverted yield curve.
And even members of the Federal Reserve such as Atlanta Federal Reserve President Bostic (picture below) and Neel Kashkari (in a post on Medium here) the President of the Minneapolis Federal Reserve are openly talking about the inversion of the yield curve and what it means for the economy.
It remains to be seen whether the signal works this time.
Since 1988 stocks have always produced a negative 10 year return when the Forward Price to Earnings ratio was 22 or higher. This chart says nothing about 1 year returns. Then returns are all over the place whether the Forward P/E is 12 or 22. Although you can see from the chart that positive returns are lower 1 year out compared to when the Forward P/E is lower.
This data is for the US and I have no idea what these charts would look like if you would take an index like the Nikkei 225 or a European index such as the Euro Stoxx 50 or the AEX Index.
If you invest on a long term basis the lower the Forward P/E for the market the better your return could be.
As of the end of June 2019, the Forward P/E for the S&P 500 is 16.9. This was above the average of the last 30 years. This average is skewed to the upside though because of the extreme valuations during the 2000’s Dot-com bubble in stocks.
The balance sheet of the Federal Reserve has been big in the past as can be seen in the below chart. This chart depicts the balance sheet to GDP ratio of the Federal Reserve from 1913 till 2012. The Federal Reserve was created in the year 1913.
After the crash of 1929 the balance sheet had to be increased in order to save the economy. The balance sheet to GDP ratio hit a high of 23% right at the start of World War II. Since then it had slowly trended lower to 5% of GDP until the financial crisis of 2008 hit.
Here is a chart which has the balance sheet since today. As can be seen from the chart is that the Fed’s balance sheet started rising after the financial crisis and hit a high of $ 4.4 trillion in 2014 when the Fed ended the QE program. In 2018 the Fed chose to unwind the balance sheet.
Right now the Federal Reserve balance sheet to GDP ratio sits around 18% after having hit a high of 25% in 2014. This is explained by the Fed unwinding the balance sheet from 2018 and the rise in US GDP.