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The U.S. Yield Curve Has Still Not Truly Inverted

While the 10-year has closed below some shorter-term rates several times in 2019, I do not believe that this is a kosher inversion.

The 10-year Treasury closed at 2.50% on Friday while the 2-year note closed at 2.29%. That’s a positive 2-10 spread of 21 basis points. As the classic measure of the slope of the Treasury yield curve, that means it has not yet inverted. It is true that the 10-year Treasury closed below some shorter-term government rates like T-bills and the like quite a few times in 2019, but I do not believe that this is a kosher inversion.

Longer-term Treasury yields are being pulled by action in the German and Japanese bond markets, where 10-year bunds close at -0.02% while 10-year JGBs closed at -0.03%. There simply isn’t enough yield in key global bond markets, so multinational financial companies end up in the U.S. Treasury market.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This is what is behind the fresh 52-week high in the U.S. Dollar Index and the fresh 52-week low in the euro. Europe has a deflationary problem that the delayed Brexit has intensified. In that environment, I expect further gains in the dollar and further lows in the euro. Under a certain scenario that is not all that unlikely, the euro can hit parity (1:1) to the U.S. dollar later in 2019.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I don’t base my decisions on the fascinating world of charts alone, but there is a “head-and-shoulders top” in the euro with the head near $1.25 and the “neckline” around $1.12-1.13. The breakdown below that neckline, which happened last week, points to an exchange rate of $1. The way the currency markets work is that they stay in a state of suppressed volatility for a while and then they violently break in the direction where the imbalances have been building up. That direction for the euro is down.

If U.S. interest rates rebound later in 2019 because of better U.S. economic performance, this will expand the interest-rate differential again in favor of the U.S. dollar and it will have nowhere to go but up, particularly if the “trade deal of the century” with China is a done deal by then.

U.S. interest rates have a chance of rebounding as major tax cuts tend to have a second surge in economic activity, which may come by the end of 2019. There was a similar pattern following the 2003 Bush tax cuts, in which there was a first sugar high, a pause, and then another second wave of heightened economic activity. The same pattern may happen now, which would mean no recession in either 2019 or 2020.

Implications for the Stock Market

The Nasdaq 100 and the S&P 500 have already made fresh closing highs and the Dow Industrials are less than 1% off all-time highs. Unless the Chinese trade deal that is 90% done completely fails because of some dumb holdup, we are likely to see further gains in share prices in 2019. I know the stock market is up a lot in 2019, but that’s simply normalizing the abnormal performance in 4Q’18. Stocks today are where they were at the end of last September, after experiencing a giant swoon lower and a surge higher.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

December 2018 (through Christmas Eve) was the worst December since 1931. It was truly a challenge to explain to clients that sell-offs in a good and growing economy tend to reverse pretty quickly. Not every sell-off in a good economy reverses immediately, but they are very different than real bear markets, where earnings per share (EPS) for the index tends to shrink dramatically for 1-2 years during a recession.

The fact that EPS for the S&P 500 could decline marginally when all companies have reported is not real “shrinkage,” as George Costanza would say. This is simply a factor of the sugar rush from the Trump tax cuts and the fact that EPS growth in Q1, Q2, and Q3 in 2018 was very strong. EPS growth should return by late 2019 and into 2020.

A lot of investors are scratching their heads as the stock market is going up “without earnings.” That’s simply a lack of perspective. Today’s stock market action is just a mirror image of it going down lot in Q4 2018 “with earnings,” or a “reversion to the mean” of sorts. The stock market is a forward-looking mechanism. What the stock market sees right now is no recession in 2020 and normalized EPS growth.

I do not believe that the Fed overshot on monetary tightening, but because the pace of quantitative tightening (aka, balance sheet shrinkage) picked up so dramatically in 2018, that alone could be the simplest explanation for the pickup in volatility in 2018. Quantitative tightening is simply the removal of electronic cash from the financial system. It is still ongoing as the shrinking Fed balance sheet indicates.

Also, the Trump Twitter attacks on the Fed Chairman did not help, nor did Chairman Powell’s backlash at the President by sounding firmer than appropriate at the December 19 FOMC press conference and his “autopilot” comments when it comes to the Fed balance sheet. With a President like Donald Trump, it is admittedly easy to lose one’s temper, particularly if one is the subject of his legendary Twitter diatribes.

Chairman Powell appears to have learned a valuable lesson that, as a Fed Chairman, it’s not just what you say that moves the markets, but it’s also how you say it.

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