An Updated Look at the Yield Curve and Stock Market Volatility
Thursday, December 13, 2018

Last week, the yield on the five-year Treasury note fell below that of the two-year note. Any investor could have realized a higher yield for tying up their money for only two years rather than for five years. The yield curve—which plots the interest rates for Treasuries of varying maturities—is not supposed to work this way. Under normal circumstances, investors demand higher rates of return for parting with the money over longer periods of time.

Over the seven-day trading period of December 3, 2018, through December 12, 2018, the relative yield of the five-year Treasury compared to its two-year brethren has ranged between a low of –3 basis points (–0.03%) to a high of zero. The negative difference indicates an inverted yield curve (the curve slopes down from shorter to longer maturities) while the equal yields indicate a flat yield curve (the curve resembles a straight line).

The inversion of the five- versus two-year yields drew attention when it first occurred last week. Lower yields for longer-dated Treasuries relative to shorter-dated Treasuries suggest traders expect economic conditions to soften, thereby easing inflationary pressures. If, in contrast, they expect inflation pressures to intensify, they would demand higher yields on longer-dated bonds to compensate for the expected loss of purchasing power.

While the two- to five-year rates got attention, the bigger yield comparison to watch is the two-year Treasury note versus the 10-year note. This is the yield curve I discussed back in May. An updated version of the chart is shown to the right. While the 10-year note continues to yield more than the two-year note, the gap is narrowing.

Many market observers watch how this part of the yield curve changes over time because it can be an economic canary in the coal mine. Since the mid-1970s, every economic recession in the U.S. was preceded by an inverted yield curve, observed Michael W. Klein of Tufts University on the EconoFact website. Specifically, recessions followed periods when the 10-year Treasury note’s yield fell below that of the two-year note’s yield. In such scenarios, you could get a higher interest rate for locking your money up for just two years as opposed to 10 years.

Though the yield curve measured on this basis has become flatter, it has yet to invert (meaning yields on the 10-year note are higher than those of the two-year note). Even if the curve were to invert, it does not mean a recession is imminent. Rather, prior to the 2008 financial crisis, the length of time between inversion and the start of the recession has varied between 10 and 18 months. Plus, the relationship is not causal. Inverted yield curves don’t lead to recessions but rather reflect heightened fears about the possibility of a recession occurring—a big difference.

It’s within the range of possibilities for a pausing of rate hikes by the Federal Reserve to impact trader’s sentiment and thereby the slope of the yield curve. The CME’s FedWatch Tool assigns less than 25% odds of more than one rate hike occurring next year. A quarter-point rate hike should be announced at next week’s meeting and then potentially just one more next summer. The futures market is pricing in less than a 25% probability of a second 2019 hike occurring. These forecasts are subject to change.

A separate, though related, indicator of recessions is housing starts. Seven out of the last eight recessions were preceded or accompanied by a drop of at least 30% in housing starts according to Sam Stovall, chief investment strategist at CFRA Research. Though the housing market has weakened, it’s nowhere near recessionary levels. Housing starts in October 2018 were down just 2.9% from October 2017. November data will be released on Tuesday.

As far as the stock market’s volatility is concerned, any perception you may have of it intensifying over the past two months is justified. Since October 11, the S&P 500 index has closed up or down by at least 2% on nine separate days. The full-year total for such moves was lower than this during four out of the last six years (2012, 2013, 2014 and 2017). In total, 2018 has incurred 16 days with a daily change of more than 2% and 57 days with a daily change of more than 1%. When volatility is measured on an intraday basis, it remains lower than the average amount realized since 1962 according to Howard Silverblatt at S&P Dow Jones Indices.

The market feels more volatile now because it is coming out of an extended period of relative calm. We haven’t experienced a volatile year since 2011, which saw 35 days with a move of more than 2% and 96 days with a move of more than 1%. Relative to last year, which saw no days with a 2% closing change or a 2% intraday swing, 2018 feels like a rollercoaster.

Spikes in volatility do not always precede recessions. To quote Benjamin Graham, “in the short run, the market is a voting machine.” Traders tend to act first and ask later. While the stock market is forward-looking, it often sways too quickly and too far. So rather than reacting to it or the bond market, take a long-term view and consider a broader range of indicators than what is discussed in the daily and real-time news headlines.

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Highlights from this month's AAII Journal

The Week Ahead

The first group of early fourth-quarter reporters will announce their earnings next week. There are 14 S&P 500 companies on the calendar including Dow Jones industrial average components Nike Inc. (NKE) and Walgreens Boot Alliance Inc. (WBA), both of whom will report on Thursday.

The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. Interest rates are projected to be raised by 0.25%. The meeting announcement and updated committee member forecasts will be released at approximately 2:00 p.m. Eastern Time on Wednesday. Chairman Jerome Powell will hold a quarterly press conference at 2:30 p.m.

Elsewhere on the economic calendar, the December Empire State Manufacturing Survey and the December housing market index will be released on Monday. Tuesday will feature November housing starts. November existing home sales will be released on Wednesday. Thursday will feature the December Philadelphia Federal Reserve business outlook survey. November durable goods orders, the final revision to third-quarter GDP, November personal income and outlays and the University of Michigan’s final December consumer sentiment will be released on Friday.

The Treasury Department will auction $14 billion in five-year TIPS on Thursday.

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AAII Sentiment Survey

Pessimism among individual investors jumped to its highest level in more than five and a half years in the latest AAII Sentiment Survey. Optimism plunged, and neutral sentiment declined.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 17.0 percentage points to 20.9%. Optimism was last lower on May 25, 2016 (17.8%). The drop keeps optimism below its historical average of 38.5% for the 12th time in 14 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, pulled back by 1.3 percentage points to 30.2%. Neutral sentiment is below its historical average of 31.0% for the sixth time in seven weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked by 18.4 percentage points to 48.9%. This is the highest level of pessimism registered by our survey since April 11, 2013 (54.5%). The large increase keeps bearish sentiment above its historical average of 30.5% for the 10th consecutive week and the 13th out of the last 14 weeks.

This week’s jump in pessimism is tied for the 24th-largest weekly increase in our survey’s history. (The AAII Sentiment Survey started in 1987.) It is also the largest weekly increase since April 2013.

At current levels, pessimism is unusually high and optimism is unusually low. Historically, both have been followed by higher-than-median six- and 12-month returns for the S&P 500 index, particularly unusually low optimism.

The survey period runs from Thursday through Wednesday. Reminders to take the survey are emailed to a rotating group of AAII members every Monday. About half of this week’s votes were placed on Monday and more than 80% were cast between Thursday and Monday.

Many AAII individual investors have not altered their strategies in response to the ongoing volatility. This is not universally the case, as there are some individual investors who have taken a more defensive posture. Cash allocations reached a 33-month high last month according to our November Asset Allocation Survey. Other than market volatility, influencing individual investors’ outlook are Washington politics (including President Donald Trump and the change in House leadership), tariffs (particularly the ongoing trade war with China), corporate earnings, the Federal Reserve, valuations and concerns about the pace of economic growth.

This week’s special question asked AAII members how they expect the U.S. economy will perform over the next six to 12 months. Responses varied. The largest group of members (25%) expect the economy to continue growing, but at a slower pace than this year. Nearly 13% expect growth to remain at a good pace or at least 3%. About 14% expect economic growth to be flat, slightly up or slightly down. Just under 13% think the economy will slow or even fall into recession. Some members say their outlook is dependent on what happens with the trade war (7%) or what the Federal Reserve does with interest rates (3%).

Here is a sampling of the responses:

  • “Steady but growing at a slower rate than in 2018.”
  • “Flat to down. I think a lot will depend on what happens with the tariffs and China.”
  • “Good, but not great. Growing at 3%.”
  • “Once the trade dispute is solved, I think the economy will do fairly well.”
  • “Growth will slow with a risk of a recession, especially if trade tensions persist.”


This week’s Sentiment Survey results:

Bullish: 20.9%, down 17.0 points
Neutral: 30.2%, down 1.3 points
Bearish: 48.9%, up 18.4 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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