The Dividend Cafe - Colluding with The Yield Curve

Episode Date: March 29, 2019

Topics discussed: And Germany is the Good One Growth story for the next decade The Fed's Special Counsel Investigation is called the Bond Market Links mentioned in this episode: TheBahnsenGroup.com

Welcome to the Dividend Cafe, not by a lot. As a matter of fact, some people might have expected, and I don't know why they would have, but some people might have expected the market would be up a lot this week with the results of the Mueller investigation, the special counsel releasing their report last week, exonerating the president around collusion and putting an end to this kind of big sort of dramatic story that's now been going on for nearly two calendar years in our country. And if you want a little unpacking of that story, I'm not going to do it in this podcast here because I thought it was worthy of its own treatment. And so this week's Advice and Insights podcast is dedicated completely to that subject, the Mueller report, the geopolitical

ramifications in the market, what it means for election 2020, what markets care about, don't care about, and how this entire kind of Russian collusion accusation saga has meant to markets all the way through. Please do, if you're interested in that subject, check out the Advice and Insights podcast. But if what you're looking for is a little overview of our whole entire weekly market commentary, then you've come to the right place here at the Dividend Cafe. Okay, first things first, the yield curve has inverted. And I wrote months ago why I wasn't of the opinion that the five-year yield and three-year yield inverting necessarily counted. three-month, six-month, and one-year treasury are all higher than the yield on a five-year,

seven-year, and 10-year treasury. There is no denying the classic inversion that we now see. Now, there's significant basis for blaming this on overseas buyers. As you will hear in a moment, Germany is in free fall. Economically, the country of Germany is in free fall. And it's led to a real drive for longer duration in the bond purchases of global investors that are looking for safety and higher yields. Those investors had been on the sidelines out of fear of dollar volatility and let's just say that that tune has now changed. Imagine not buying a 10-year treasury at 3.25% because you're worried about rising rates but now flooding into the same treasuries at 2.5% just a few months later. That's literally the state of affairs.

I've not seen a situation like this in my career. U.S. bond yields coming lower even as growth is accelerating. Why? Because bond yields are collapsing in Europe, pulling U.S. bond yields down with them. And why are yields collapsing in Europe? Because projections for growth are collapsing, particularly in Germany. Yes, Germany is the strongest economy

in Europe, but I'll quote the legendary economist Charles Gove in unpacking what this has created. Germany is, and I'm quoting Charles now, Germany is also Europe's weakest link. is, and I'm quoting Charles now, Germany is also Europe's weakest link. Its industry has been supported for too long by artificially low interest rates, artificially low exchange rates, and an unsustainable system of vendor finance to Southern Europe, which is now coming apart at the seams. Amidst apparent prosperity, capital is being destroyed on a massive scale in Germany. And if you go to our dividendcafe.com this week, you'll see I put a chart up from Bloomberg of the German 10-year bond yield and what has happened to it over the last couple of months and how it coincides with the manufacturing data, their PMI reading in Germany. You may not be able to

formulate an easy U.S. bond investment thesis around all this because if the same buyers you just got comfortable with the dollar were to see the dollar soften, you may very well see the panic buying of treasuries turn into panic selling real quickly. And that, of course, would push yields higher. But the major issue I'm highlighting right now is that things are not good in Europe, especially Germany. And that really does have an impact in the U.S. treasury market. So the bond market is basically serving as sort of a special counsel for the Fed, if you'll accept my pun. Look, I've offered as much commentary about the Fed as any advisor or portfolio manager could muster. I've done so for years. But all the pontificating

I've done so for years. But all the pontificating notwithstanding, the yield curve is now telling the Fed, you tightened too much. It is tough to be overly critical of the Fed. Wages are at record levels. Economic growth has substantially improved the last couple of years. Economic conditions are good. Monetary policy was not aligned with an economy as strong as we're often told that it is and as the data suggests that it is. So one can forgive the Fed for attempting to take advantage of the good times of 2017 and 2018 to normalize rates and their excess reserves or at least take

steps towards that normalization. But what we have now is a yield curve that reflects Fed policy at the short end of the curve and disagreement with Fed policy at the 5 to 30 year end of the curve. Could the Fed cut rates out of this? It's not out of the question, even though I do believe it'd be a policy mistake. Long rates get their signal from short rates too. And all a cut does is further reiterate to the bond market that the Fed views the economy in the context of a long-term secular low rate environment. It further weakens the Fed's hand when the next recession comes. It risks malinvestment in credit markets. So all that said, will it happen? Well, the futures market now has a 60% to 70% chance of some rate cut before the end of the year.

The forecasts there are all divergent in the magnitude and timing of the cut. But nevertheless, some form of cuts now become the prevalent scenario in the futures market. Well, markets never sleep, neither should advisors. So what about markets? I would not advise paying close attention to anyone who would project what this all means for risk assets, at least not with any high degree of confidence. On one hand, an inverted curve has always preceded a recession. But on the other hand, the time between the point of inversion and the onset of recession has varied from nine months to three years. Additionally, the Fed has now promised the end of its balance sheet reduction, so-called quantitative tightening, which could very well enhance credit market conditions and

boost risk assets further. I love a chart I put in Dividend Cafe this week from GAFCAL data about the Fed's balance sheet, how much they had contracted and what its composition looks like right now between currency and circulation, their required reserves, and then those so-called excess reserves that quantitative easing represents. Let's move on to the China trade deal that obviously is looming over markets as well. The latest development is that China is now offering to open their data centers to U.S. companies, which is a big deal. The hang up continues to be that on the rather substantial concessions they're offering to make around technology and new markets. They're asking for legacy tariffs to be removed, and the U.S. is just not there yet.

Meetings are taking place as I speak. The story remains in flux. But a reminder of our view, much of a final China deal is already priced into markets. There exist certain elements of a deal that could make it better than markets are priced. So this story continues to be monitored. By the way, I do plan to write a market epicurean in the month of April. I meant to maybe write it this week and just realized I wanted to do a deep enough project that it wasn't going to fit into my schedule this week. But I've tasked myself in April a pretty exhaustive unpacking of the U.S. oil and gas story as it pertains to our production and what this incredible resurgence of production growth and still growing production growth means in terms of a catalyst to broader macroeconomic growth in the years ahead, what it means to investors and so forth. So I'll talk a lot more about that story and why it is still the driver of our midstream

energy infrastructure investment thesis, which we're deeply committed to. Brexit, by the way, the March 29th deadline was moved to April 12th, and the European Union has said they will not force a hard no-deal Brexit at that time. You know what? The sterling pound is the second best-performing currency in the world year to date, even with all the uncertainty and fear-mongering that's out there. What do we know? Well, really nothing

besides that. I don't know if Theresa May will end up in a constitutional crisis with her own parliament. I think it certainly could happen. We don't know what market disruptive outcomes are less likely or more likely. So we wait and continue to have a lot of confidence that a Brexit gets done and that that Brexit will not be disruptive to markets beyond short-term noise. Like I said, a full discussion of the Mueller report is available at the Advice and Insights podcast. Another political development this week started off with the Senate Banking Committee holding hearings to discuss the idea of some mortgage-backed securities competition for our old friends Fannie Mae and Freddie Mac.

But then President Trump himself entered the fray Wednesday by ordering the Treasury Department and he sent a memo to his HUD secretary, Housing and Urban Development head Ben Carson, demanding some sort of credible ideas to end the government's control of Fannie and Freddie. The conditions that they're saying they want are for Fannie and Freddie to be untangled from government control. from government control, and that would include somehow the government and therefore the taxpayers being compensated for the risk that they took being the implicit guarantor, which of course became a more explicit guarantor in the last decade. Just keep in mind, it's March 2019. Fannie and Freddie went into taxpayer conservatorship in September of 2008. So here

we are. All right. Chart of the week at the Dividend Cafe showing you the performance of the stock market when we have an earnings recession, when there's also an economic downturn. And then showing you the average stock market all the time, and then showing you the performance of the stock market when we have an earnings recession, but not an economic downturn. And you'll see that the stock market has actually outperformed itself. When we have an earnings recession, but not an economic downturn, the market in the 12 months ahead has

tended to actually outperform its own annual average. Check out the chart. It's really interesting stuff. I'm going to close, which I don't often do in the podcast. Sometimes I do. I should do it every week because I love these quotes. But I'm going to close this week with the quote of the week from the Dividend Cafe weekly commentary. And that is from Dr. Nassim Taleb, one of the great influencers in my life ideologically, who I follow vigorously. I've read every word I think he's ever written. And that is, if your private life conflicts with your intellectual opinions, it cancels your intellectual ideas, not your private life. Think about that for a little bit and make some time this weekend to watch some college basketball.

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