Is There Really a Santa Claus?

Wednesday was one of those amazing days with the S&P 500 index rising 3% for the day! The bull must be back, right? Not so fast… We’ve said this a few times in the past, but we’ll say it again. The best days in stock market history have occurred in bear markets!

While the +3% day we had this week was impressive, it still isn’t close to being the best. Nevertheless, we note that 20 best daily percentage gains (below) all occurred in a bear market. These big up days can be a welcome gift when markets are tough, but don’t read too much into it. Year-end ‘Santa Claus’ rallies may be real, but Santa Claus is not.

Spreads, Curves and Inversions

The banter about the terminal rate, the yield curve, inversions, etc. are seemingly endless in financial media and they get plenty of attention in the MSM too. We are probably as guilty as any about tossing around these terms without much consideration to our readers, so we thought it would be a good idea to explain a bit about what these things are and some theories about why they happen. Keep reading, and begin to understand the financial news today.

What’s important?

Yield curve inversions do not cause recessions.
Yield curve inversions have been mostly reliable, but are not perfect, in predicting recessions.
The current inversion is the steepest since the early 1980’s and is giving a warning which should not be ignored. Hope for the best, but prepare for the worst. Tougher times probably lie ahead in 2023

Spreads

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. Given this definition, there a lots of different yield curves out there, but the most important is the Treasury yield curve because the treasuries are considered ‘risk free’. Risk free doesn’t mean that you can’t lose money, it simply means that there is a virtually 100% chance that the interest and principal payments of your Treasury bonds will be paid (i.e., there is no credit risk). Other bonds that are not guaranteed by the government have some higher level of credit risk and those bonds should have higher yields than government bonds. For example, bonds rated BBB, rather than AAA, would have higher yields, otherwise called a spread. If the 10-year Treasury is trading at a yield of 4% and BBB bonds are trading at a yield of 7%, the spread is 3%. Spreads vary over time based on economic conditions. When things are good, spreads can be very low, but when the economy gets skittish and risks arise, that spread will widen. Don’t forget that when yields go up, bond prices go down, so when spreads widen, generally, bond prices are going down.

Curves

The Treasury yield curve is very closely watched by economists and market observers because historically, the slope of the yield curve gives an idea of future interest rate changes and economic activity.

In the chart below, the blue line depicts the yield curve on July 1, 2015. This is an example of a normal, upward sloping yield curve, where yields increase with time. (Example, the 10 year bond yields more than the 5 year bond.) The reason this is normal is that bonds should theoretically compensate investors for anticipated inflation. Over a very short time frame, it is often relatively easy to estimate where inflation will be, but over longer terms, there is more risk that an inflationary event will occur, so long term yields are normally higher than shorter term yields.

The red line in the chart below is the yield curve on November 30, 2022. It is anything but normal. The yield curve is currently inverted, meaning that short term bonds have higher yields than long term bonds. Historically an inversion of the yield curve has been an indicator of an oncoming recession although generally, the recession begins after the inversion has reversed.

Inversions

There have been 9 U.S. recessions since 1960, and in each case, an inversion of the yield curve preceded the start of the recession. The yield curve is currently inverted (in fact, very inverted) so naturally, there is concern that another recession is about to begin. But an inverted yield curve does not cause a recession, rather it is function of how markets anticipate events. But which inversions should we watch? Some pundits like to watch the 5s30s, which is the spread between the 5 year bond and the 30 year bond. Others focus on the 2s10s. In theory, the preferred measure of the Federal Reserve is the 3mo10s.

The simple answer is that when markets ‘see’ a recession coming, investors prefer long term bonds. The reason is that when recession strikes, the Fed responds by lowering interest rates. Long term bonds respond much more positively to falling rates than short term bonds and therefore offer greater profit opportunity. (Again, don’t forget that when rates go down, bond prices go up.) The result is that the natural market reaction to the recognition that economic weakness is approaching is to sell short term bonds and buy longer term bonds. When there are more sellers than buyers for short term bonds, prices go down (i.e., yields go up). Likewise, more buyers than sellers for long term bonds implies that prices rise (i.e., yields come down). Presto! You have a yield curve inversion.

Recessions

The yield curve has been a reliable recession indicator, but we always look to verify trends with other data. One such piece of data is called the Weekly Economic Index, from the NY Fed. This index tracks 10 weekly and daily data points that cover consumer behavior, the labor market, and production. These are used to track the likely path of economic activity and it is shown below. The 10 data points are:

Initial unemployment insurance claims
Continuing unemployment insurance claims
Federal taxes withheld
Redbook same-store sales
Rasmussen Consumer Index
The American Staffing Association Staffing Index
Raw steel production
U.S. railroad traffic
U.S. fuel sales to end users
U.S. electricity output

The index level is now back where it was before the pandemic, but the trend remains firmly down. If this index continues the downtrend, indications of a recession will become much clearer.