With stock indexes sagging by 1% Tuesday and mired in a nervous months-long trading range, market handicappers are comforting themselves and their clients with a pair of historically trustworthy indicators that say, “Don’t worry too much.” But given that these gauges of financial-market calm are a direct result of today’s extraordinary Fed policy of pegging short-term interest rates near zero, it may be worth asking whether they can be fully trusted in the current cycle.
Every bear market in stocks – defined as at least a 20% drop in the Standard & Poor’s 500 index – over the past half-century has been preceded by an inverted Treasury yield curve, meaning short-term rates exceed longer-term bond yields. That’s not nearly the case now, as three-month Treasury bills at 0.03% are almost 2.50 percentage points below the 10-year yield.
LPL Financial strategist Jeff Kleintop is among those leaning on this clue, telling clients last week: “The best indicator for the start of a bear market may still be a long way from signaling a cause for concern.” Bull markets typically are killed by the Federal Reserve lifting short rates and braking an economic expansion. While the curve has flattened with the Treasury rally this year, it's still pretty steep by historical standards.
Beyond an inverted yield curve, severe equity-market downdrafts and recessions are typically preceded by weaker credit conditions. Yields on riskier corporate debt tend to climb relative to safer bonds as fixed-income investors begin to sniff out economic deceleration that will stress corporate balance sheets. Today the credit markets remain remarkably strong, with junk-rated debt strongly bid by global investors craving decent yield in a low-rate world.
These reassuring signals pinging from the beacons of the typically “smarter,” forward-looking fixed-income markets seem to tell us any ongoing stock-market tossing and lurching likely doesn't signal the "Big One” that will run this bull market aground.
But how much should these signals really be assuaging investors' fears?
For sure, the prospect of an inverted yield curve appears years away, even if the bond market rally that has ambushed so many this year barrels on and drives 10-year Treasury yields far lower. The Fed has kept the federal funds rate just above zero since 2008, and has vowed to keep it there for a good while after its bond-buying program expires. (That said, the market's Tuesday rout has in part been attributed to Fed comments indicating rate hikes may come sooner than expected.)
Erik Swarts, a trader who blogs at Market Anthropology, suggests that using Treasury curve inversion as the sole tripwire for anticipating a possible bear market is misguided now.
“The signal is likely less than binary this time around the block and a result of the low interest rate environment we currently find ourselves trudging through,” Swarts says, pointing out that the U.S. had six recessions between 1935 and 1965 without inversion, and Japan five in two decades – all in times of profoundly low rates.
It’s difficult to see absolute yield levels for junk debt falling much from current levels near 5%, so the high yield might not lend much incremental impetus for further equity gains. Still, it would also be odd to see stocks undergo more than a fairly mild pullback without corporate credit conditions softening up a fair bit. (Yields on some lower-rated government debt in peripheral Europe have lifted in recent days, and junk-bond spreads have lifted, small measures of waning confidence that bear watching.)
Some are arguing, though, that the blind rush for scarce yield alone is fortifying the credit markets, and fouling what is normally a reliable signal of rougher financial conditions. The Wall Street Journal nicely documents the binge for riskier, slightly higher-yielding debt, as investors lock in the income with little fear of an imminent wave of defaults.
As described here before, the Fed’s stimulative policies have nicely bailed out subprime companies, allowing most to refinance and extend their debt obligations and at least defer a day of reckoning.
So if buyers of lower-rated debt are insensitive to price and willing to accept ever-lower yields – which in turn are anchored by central banks’ emergency-level zero interest rate stance – should we believe the credit market’s sanguine message?
These are the questions thoughtful investors are struggling with. For what it's worth, it's probably positive that there is so much unease with the underpinnings of financial-market strength, with so many giving too much credit to Fed policy. This keeps the reservoir of skepticism reasonably well supplied. Even for those who grant that economic and corporate strength have been strong drivers of the bull market, getting a clear read on the outlook is complicated by dissonance in the way markets are acting now.
Reckless … and fearless?
There is an unusual blend of recklessness and fearfulness in evidence, depending on where one looks.
Blissfully strong junk-bond conditions usually support riskier small-cap stocks. But the small-cap Russell 2000 has dropped 7.5% since March 4, with the S&P 500 remaining flat, supported by “safer” sectors such as utilities and telecom stocks that thrive in an anxious tape.
Companies, meantime, continue to resist funneling cash to heavy capital investments, yet they are increasingly launching big acquisitions as the need to “buy growth” becomes acute. So far in 2014, more $10 billion-plus deals have been struck than at the same point in any prior year.
The title of Merrill Lynch’s latest monthly look at asset flows captures the odd coexistence of heedlessness and caution in investor appetites: “Frothy Inflows, Speculative Fervor AND High Cash Levels.”
This all speaks to a certain forced nature of the risk-taking behavior driving investor behavior. Low rates and high liquidity have squeezed global investors into riskier assets and smothered market volatility. Yet uncertainty over the global growth path and wariness over policy risks has made the embrace of risk a joyless one, with little of the sky’s-the-limit confidence and new-era euphoria that frequently accompany investment booms and, ultimately, market peaks.
It’s probably fitting, then, that the proportion of investors who say they are “neutral” on the outlook for stocks – otherwise known as confused – is at an eight-year high.
This backdrop is quite consistent with a continuation of the sort of frustrating, sloppy, ambiguous market action that has prevailed this spring, as markets digest huge 2013 gains and come to terms with the slow retreat and the Fed’s auto-pilot asset purchases.