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The Inverted Yield Curve and ‘Capital Flight’

A different look into what’s behind the yield curve inversion … and what to watch out for as 2019 rolls on

As you’re likely well-aware, last Wednesday, the yield curve inverted when the rate of the 10-year Treasury fell below that of the 2-year note.

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Historically, this inversion has been heralded by many as a recession indicator.

Now, you likely saw the financial media make a big deal of this, and that’s fair. It is a significant market event. That said, there are two sides to this story — both of which we tried to capture here in the Digest.

As to the inversion being a precursor to a recession, our own quant analyst, John Jagerson of Strategic Trader noted how an inverted yield curve usually precedes a bear market by about 10-18 months if we look at historical data.

The counter to this argument has roots in “this time it’s different.” Our own master income investor, Neil George, noted this perspective in the same Digest last week:

What is really happening is that the U.S. is the haven economy in a world where Europe is in trouble and the leading economies of Asia are slowing. And as a result, yields for government bonds from the leading issuers in Europe and Asia are increasingly heading into negative yields.

This in turn is making the U.S. bond market all the more attractive with positive yield and in turn is driving more buying from investors inside the U.S. and beyond. And with more buying of longer-term bonds — yields are down, and prices are up.

In today’s Digest, let’s begin by looking closer at this capital flight argument. By this measure, the inverted yield curve isn’t a terrifying harbinger of impending financial doom, but instead, is a reflection of a world in which interest rates are going negative.

We’ll then look at the effect of the inversion and lower yields on the banking sector, which suggests we’ll see another rate cut from the Fed.

Finally, we’ll wrap up by highlighting one very real danger of an inverted yield curve — regardless of its cause. Keep this on your radar as 2019 continues.

Lots to cover so let’s jump in.

***Money flows where it’s treated the best

Just like water eventually sinks to the lowest level, investment capital tends to find its way to the highest-yielding investments. And that’s never been truer than today, when technological advancements have opened up international markets for investors like you and me.

After all, why should I limit myself to a yield on Bond A of 1.5% when Bond B is yielding 3%? Today, reallocating into higher-yielding assets is usually as simple as a few clicks.

This is at the heart of the “capital flight” argument.

Today, roughly $15 trillion of government bonds worldwide trades at negative yields. To put that into perspective, that’s about 25% of the entire sovereign bond market. This figure has almost tripled since October 2018.

Now, backing up for just a moment to make sure we’re on the same page, why are governments pushing their yields into negative territory?

In short, they’re trying to jumpstart sputtering economies. Traditionally, government bonds have been a safe place to park funds. So, as the theory goes, if you make investors take a loss on that safe investment, they’ll be forced to put their money back into circulation and into riskier assets, which jump-starts spending, the economy, and the stock markets.

Returning to our capital flight focus … Let’s say you’re a German investor. As I write, the German 10-year bond yields roughly -0.68%. Comparatively, the U.S. 10-year bond yields roughly 1.6%.

That’s a no-brainer decision, right?

Proponents of the capital flight argument suggest this is what’s behind the drop in U.S. bond yields. All of this foreign money is flooding into the U.S. Treasury market because it’s offering better returns. This is what’s pushing down yields (and pushing up prices) — as opposed to fears of deteriorating economic conditions here in the U.S., which traditionally, is often what causes depressed yields and an inversion.

***Regardless of the reason, an inverted yield curve is bad news for U.S. banks, and that suggests we’ll see more rate cuts from the Fed

Banks make money by charging borrowers higher long-term interest rates while paying smaller interest rates to depositors. The spread between these rates is their profit.

When the yield curve inverts, or settles around the same level, there isn’t sufficient spread for the banks to make much money. This leads to a decline in earnings, which is bad for bank investors. Far worse, it’s bad for the economy if the financial health of the bank is truly jeopardized.

Yesterday, Louis Navellier commented on this to his Accelerated Profits subscribers, noting how this was likely to lead to more rate cuts. From Louis:

What we need to remember is that the Federal Reserve is essentially “tethered” to market rates … Now, the Fed never fights market rates. So, it’s growing more likely that the Fed will cut key interest rates at least two more times this year in an attempt to un-invert the yield curve. Remember, an inverted yield curve is devastating to the operating margins of banks that the Fed regulates.

This week holds the annual gathering of central bankers from around the world in Jackson Hole for a summit that will focus on monetary policy. Wall Street will be looking to Powell, who speaks Friday, for clues as to when we’ll see more rate cuts.

As it stands today, expectations for a quarter-point rate cut by the September 18 Fed meeting stand at 95%, as you can see below.

Back to Louis:

I expect that Fed Chair Jerome Powell will signal that another 0.25% key interest rate cut will be forthcoming — and that should boost the stock market heading into the Labor Day holiday weekend next week.

***Regardless of what’s behind our inversion and the lower rates, watch out for this very real danger

At the end of the day, it’s all-but-impossible to separate investor sentiment from market prices.

For example, in a roaring bull market, it doesn’t matter if market valuations are at nosebleed levels. Euphoric investor sentiment will often continue to drive prices higher.

On the flip side, in a dismal bear market, even once-in-a-decade, rock-bottom stock-prices won’t always lure investors back into the market if the sentiment is fearful.

The point is simple — what investors believe is hugely influential on the market direction.

Now, yesterday, we noted how fear can actually be a good thing when it comes to investment markets. It can help “deflate the balloon,” so to speak, preventing, or slowing an irrational bubble that ends in a market meltdown.

But consumer fear when it comes to our economy is different — far more threatening.

It’s often a self-reinforcing loop. Regardless of what economic conditions actually are, if consumers perceive things are deteriorating, they’ll hold tighter to their money. This, in turn, will have a very real negative impact on exact economic fundamentals many consumers are watching, which will only reinforce the fearful sentiment, leading to even less spending, which further damages the economy, and so on.

Today, we need to watch for excessively fearful sentiment from consumers and from capital allocators at corporations. If they stop spending based on the fear-mongering headlines, that’s when trouble will hit.

Mohamed El-Erian, former CEO of Pimco, recently put it this way:

A higher perceived risk of recession, even if based on distorted signals, can be dangerous if alarmist headlines lead consumers to cut back on their spending. And this would make the U.S. economy even more vulnerable to a policy mistake and/or a market accident — a possibility that is accentuated by the probability that the curve will invert in the future as Europe weakens further, trade tensions escalate and the ECB feels compelled to become more activist notwithstanding the limited likelihood of beneficial policy effects on the economy.

Just last week we saw news of sagging consumer sentiment. The University of Michigan’s sentiment index fell to its lowest level since January. Why? Survey respondents fear that U.S. tariffs that will take effect later this year could mean higher costs on consumer products, pushing the economy into a recession.

As 2019 goes on, watch for more reports about consumer confidence, and whether corporations are investing in R&D and capital expenditures. That will reflect where sentiment is in regards to our economy.

***So, what’s our best response to this?

To begin, keep a cool, level head. Even if “capital flight” isn’t at the heart of the yield curve inversion, and instead it’s signaling a recession, we’re likely months away from that happening.

During that time, you can evaluate your portfolio and make any required changes. In addition to gold, we’ve talked in the Digest about what those stock changes could be — from yesterday’s Digest:

(The risks on the horizon are) also why we suggest rotating into specific trend-investments and hand-selected, fundamentally-superior stocks that will do well regardless of what’s happening in the broader market.

As to “fundamentally-superior stocks,” that’s where Louis Navallier comes in. After all, as Louis just noted in an update to subscribers:

The bottom line is that this is a stock picker’s market.

So how do you find the best stocks to be in? Louis offers a free tool to help you evaluate the strength of your portfolio as earnings season rolls on, check out Louis’ Portfolio Grader.

As an example, I just entered Microsoft:

The tool is a fantastic way to get a quick, holistic perspective on the strength of your specific holdings. As you can see, MSFT scores an “A,” making it a great buy under Louis’ system.

You can enter your own stocks … and potentially save your portfolio if you realize it’s filled with lots of low-grade companies. It’s a great way to see how your picks shape-up under in Louis’s system, which has a track record of finding winners.

And if you’d like access to Louis’ specific picks, click here to learn more about his Accelerated Profits newsletter. If the market does wobble over coming months, Louis’ system will help keep your wealth concentrated on those fundamentally-superior stocks that should perform the best.

As to inversions, lower rates, and investor/consumer sentiment, we’ll keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg

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