Investments

Market Volatility & the Yield Spread

By Dean Barber

August 9, 2019

Today we’re going to cover the recent market volatility, interest rates, and the historical move in treasuries — also, the yield spread between the Three-Month and the 10-Year Treasury. We’re going to cover what’s going on in the stock market, why I think it’s happening, and a little bit on precious metals.

I know this update is for July, but I’m going to talk about the first week in August as well. July was a pretty benign month – there wasn’t a lot that went on. Markets were relatively flat, maybe up 1% or a bit better across the board. The month of August has not started so great. We saw a big 700-point drop on August 5th, another 300-point rebound on Tuesday, August 6th. At one point on Wednesday, August 7th the market was down about 500 points.

Market Volatility Creeps Back In

So, the market volatility we were experiencing in the latter part of last year seems to have crept back into the market. The question is, why? What’s going on? On August 7th, we had central banks across the globe cut rates, following our Federal Reserve. Three other countries cut their interest rates. Bonds across the globe really tanked across the board. And when I say the bonds tanked, what I mean is the yields fell. At one point on August 7th, the 10-Year Treasury yield was below 1.6%, for the first time almost ever. So, we’re seeing historically low yields. For the first time in history, the German 30-Year Bund is at negative rates. Japan and Italy are also seeing those negative rates along with Germany.

There was recently talk on CNBC about negative interest rates, and a few weeks ago, when I went out to MIT Sloan School of Management for a three-day executive course. One of the economic professors there was talking about how he wouldn’t be surprised to see the Federal Reserve Institute and negative interest rate policy here in the United States. And I know it doesn’t make any sense to you. It doesn’t make any sense to me, but it’s a way to try to stimulate the economy or to continue this economic expansion we have going. That’s why we’ve heard President Trump speaking so loudly about Jerome Powell, wanting him to reduce rates faster and more aggressively.

Market Volatility and the Treasury Markets

Market Volatility - Three Month and 10 Year Treasury

Figure 1 Source: ycharts.com

I want to turn your attention to the Treasury markets. I showed you this Figure 1 last month. The Three-Month Treasury is on the orange line, and the yield on the 10-Year Treasury is on the blue line. As of when this chart was put together, the 10-Year Treasury was at 1.73%, while the Three-Month was at 2.05%. We’re seeing spreads widened.

Remember, I told you this, here over the last two or three months, every single time since 1955 when the Three-Month Treasury yields higher than the 10-Year Treasury it has led to an economic recession within the next 15 months. There isn’t a specific date we’re looking for, and we’re not calling a recession. However, a lot of people out there are speculating a mild recession first quarter of next year, (or the) second quarter of next year, somewhere in those ranges. The Treasury yields are really telling us they’re anticipating there is a recession coming.

So, the question is, what we do? How do we make sure that we protect? Just on August 6th, our short-term indicator went to a negative position. And the long-term indicator has fallen precipitously in the last six or seven business days. I don’t think we’re going to see that long-term indicator hit that negative territory. The quarterly trend indicator is still positive for the U.S., but negative for international. We’ll keep you apprised if those things change. We do have some tactical models that follow those indicators. Many of those tactical models have moved some of the money out of the market. The asset allocation models are built to go through the market cycles with the asset allocations the way they were so no changes in those particular models.

The Yield Spread

Market Volatility - Three Month and 10 Year Yield Spread

Figure 2 Source: ycharts.com

Let’s take a look at Figure 2. In Figure 2, very simply is the same as Figure 1, but this is showing the yield spreads between the 10-Year and the Three-Month in the bottom section. We’re seeing some pretty big numbers here. Thirty-two basis points difference between the 10-Year and the Three-Month Treasury. Again, this is just showing more pressure on the long-term Treasury. If we think about what’s going on in the market in relation to that pressure, the market tended to ignore it so far this year.

Market Volatility - PMI YTD

Figure 3 Source: ycharts.com

If you take a look at Figure 3, it charts the markets so far this year. We had a couple of little bumps here we had the month of May. June and July kind of brought that back. But now August is bringing us back, and many people are saying we’ll be back to where we were in May. In Figure 3, one of the most important pieces here is the ISM PMI on the orange line; this is the manufacturing index. This thing has been trending downward for the last several months.

Fundamentals vs. Market Volatility and Performance

Market Volatility - PMI Last 12 Months

Figure 4 Source: ycharts.com

If we take a look Figure 4, you can see the trend downward has actually been going on now for a year. This is the last 12 month-look at the PMI which was negative 16.48%.. There, at the same time that we’ve had the stock market basically since December 24, 2018 lows doing exactly the opposite. When we talked about this last month, I said, there are one or two things have to happen. You can’t have these indexes going down, and the stock market just continues to go up. It doesn’t make sense. Fundamentally, it makes no sense. I’ve been saying the fundamentals that should drive the market and ultimately will drive the market long term, have not been driving the market.

What’s Driving the Market Then?

Causes are everywhere; it’s been the news media, it’s been the promise of interest rate cuts or the hype of a potential interest rate cuts, it’s been the promise of a deal done with China on the trade negotiations. Then when we don’t get the trade negotiations, and when we don’t get the interest rate cuts that we want, the markets throw a fit. That’s what we’re seeing happening here during these first few days in August. What it tells me and should tell you is that the markets are frothy and that there’s not a lot of juice behind what can drive this market much higher. We expect the market volatility to continue, and we do expect it will wind up in a positive range this year.

We Expect More Market Volatility

Of course, there’s always the unforeseen things, but we do expect a little bit more market volatility to kind of creep back into the market here during the third quarter. We’ll keep an eye on that and keep you abreast of what’s going on there. The most important thing that you can do is to keep in touch with your financial planner here, let’s review your financial plan. Let’s make sure that the allocations that you have a right let’s do some stress testing to your portfolio so that you can see the potential drawdown in the event that we do turn to a bear market and the economy does go into a recession.

Make sure that your plan can handle that and you can continue to stay retired or get to retirement on the dates that you want. Really that’s the critical thing. You have to keep a longer-term view. We can’t let the day to day noise that’s out there in the 24-hour-in-your-face media drive our investment decisions. You have to make those investment decisions based on fundamentals. Even though sometimes those fundamentals get ignored by the market, as I said previously, the fundamentals will always come back and drive the market eventually.

Precious Metals

Figure 5 Source: ycharts.com

Where has the money been going this year? Well, precious metals have received a lot of money. If you look at Figure 5 gold is on the blue line, gold is up 12.72% this year, most of that has come just in the last couple of months on the heels of the interest rate cut, disappointed and the escalation in the trade war with China. Copper is falling, and silver is all over the place this year. The point is, money is flowing into those safe-haven assets of gold and other precious metals.

Again, that’s just another sign that people are getting a little bit nervous about the market. The market volatility index spiked significantly going from around a 13 to about a 22. That’s a significant rise in the market volatility index. It’s simply a signal telling us we should expect more market volatility in the short term. Keep us apprised of how you’re feeling what you’re thinking. Your emotions are really important here. We want to help you understand exactly what we’re doing and how it fits into your overall retirement plan.

Do you have questions about your plan? If you’re looking for a second opinion or would like to stress-test your portfolio for the future, fill out the form below or give us a call anytime at 913-393-1000.

Dean Barber
Founder & CEO

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The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.