What the treasury yield curve is telling us for 2017? Where are we in a sector rotation cycle now?

We heard the news. Trump’s opponents argued that his protectionist will bring back jobs to native Americans, but endanger America’s position as the leader of technology and finance in the world. Trump’s protectionist policies left ex-trade partners pondering if “US treasury would be really risk free” once Trump invades the Fed community with people sharing the same ideology as him. Fed is also on the watch now by Trump, with Yellen in an awkward position as she is obliged to obey the honourable leader of United States.

I don’t get it… It’s weird that President Elected Trump seems not to be aware that encouraging Yellen to raise rates could, instead, harm America itself. A study done by Peter G. Peterson Foundation (here) found that

The Federal Reserve last raised the federal funds rate in December 2015. That was after a lengthy period of holding the federal funds rate close to zero in an effort to help the economy recover from the financial crisis.

. . .

The long-term fiscal challenges facing the United States are serious. Even though our current deficits are lower than they used to be, we are still adding an average of more than one billion dollars to our national debt load every day. Worse yet, we are headed toward a period of rising demands from unfunded entitlements in a rapidly aging society, combined with a tax system that fails to raise enough revenue and is filled with inefficient and costly tax subsidies. Many economists warn of this growth in debt – this year, both GAO and Ernst & Young also released reports this year warning about the dangers and unsustainability of U.S fiscal policy.

To be clear, the culprit here is failed fiscal policy, not our monetary policy and the Federal Reserve. Congresses and presidents of both parties, over many years, have avoided making hard choices about our budget and failed to put it on a long-run, sustainable path. In recent years, many have said that the fragile nature of the recovery meant that it was not the right time to take fiscal action. Now, as the economic recovery continues to take hold, we have the opportunity to put in place sensible and gradual reforms that will put our long-term fiscal trajectory on a sustainable path.

In my view, Trump’s fiscal stimulus seems late for the party when interest rates are rising to keep close to market’s zero curve yield. So why would Trump want a higer interest rate when it could affect the initiation of its fiscal stimulus plans, especially if he wants to lower taxes.

After his election victory, yields spiked and net interest margins shoot up so much so that banks appeared extremely undervalued, which triggered its price rally thereafter. Those who do not really know Trump, might simply think, this movements ought to be attributed to Trump’s promise to carry out more fiscal stimulus. But in fact, a bond selloff triggered the yields to spike up. Note that demand for US treasuries were already weak before the election, suggesting doubts of “no chance of defaults”. And, and, its not only in the US, many other countries in EM are also facing a bond selloff, so much so that it could eventually find trouble with books of portfolio managers with large exposures to those affected bonds (that same part of the curve and coupon) and raise worries of a VaR shock for funds. Suppose the bond-equity rotation is true, and that managers have parked into equities from bonds, then any upcoming fall in equities would make that chance higher? Despite these fears, the market is actually going with Trump ideology to make America great again. Industrial sector went up with crude oil and copper, an invaluable input for any industrial activities (and hence sensitive), shows that all is ready for the next wave of economic pick up.

On that note, I would like to share a great article I saw recently.. (here’s the link)

Stocks and bonds move opposite each other under normal circumstances. Generally speaking, there are two exceptions (and probably a ton more, but let’s keep it simple), one good, one bad:

  1. Post-crisis, coordinated global easing created a “rising tide that lifted all boats,” meaning stocks and bonds rallied together. That’s good.
  2. When yields rise quickly for whatever reason (i.e. when people are panic-selling bonds), stocks and bonds can fall together as the market paradoxically interprets the selling of safe-havens as a risk-off event. That’s bad.

There’s a creeping suspicion among some analysts that some time in the not-so-distant future, circumstances may conspire to trigger a VaR shock. Simply put, rates volatility reinforces a bond selloff and, seeing the carnage, equities plunge in unison.

Note that this isn’t some kind of far-fetched notion. It happens relatively often. The infamous “taper tantrum” was a VaR shock. For those who might not have seen this chart, here’s a little visual context for bond market drawdowns:

47439673-14860524716787388_origin(Chart: BofAML)

The problem is, we’ve become so used to rock bottom rates that the threshold beyond which stocks respond negatively to Treasury drawdowns has fallen – significantly.

Generally speaking, you used to have to see a move beyond 5% in 10s for equities to respond in kind (i.e. sell off). Now, that threshold appears to be about 3%. We’re at 2.46% now.

The post linked above shows you the extent to which the equity risk premium gives equity investors a cushion. Here’s the chart again:

47439673-14860527312553918_origin

So where are we in the sector rotation cycle? Sam Stovall popularised the concept of sector rotation  and many professional money asset managers are using this as a tool to guide their decisions in capital allocation.

Citing invaluable materials from here:

sectorcycle

Stage: Full Recession Early Recovery Full Recovery Early Recession
Consumer Expectations: Reviving Rising Declining Falling Sharply
Industrial Production: Bottoming Out Rising Flat Falling
Interest Rates: Falling Bottoming Out Rising Rapidly (Fed) Peaking
Yield Curve: Normal Normal (Steep) Flattening Out Flat/Inverted

We should see a steepening of yield curve, raising industrial production and consumer expectations and rates bottoming out. More or less, its all ticked and talks of reflation trades are everywhere. To see the progress of sector rotation, I shared a python script where anyone without paid market vendor access (e.g. Bloomberg) can access and see charts of the current yield term structure. (Do comment your thanks if you like it!) I left it un-interpolated so that its easier to see the change for each maturity, but i have created a function to interpolate the periods in between too.

A short history of rate term structure slope that spans 2007-2008 financial crisis

Source (all pictures): Python, Quandl. Annotation refers to the picture below it.

January 2006 – rates high at 4% level, higher for longer duration

y-jan-06

June 2006 – present rates elevated around 5%, above 1 year rates back around 4%, but end of the curve cannot go any higher (signs of overheating). SPX eventually peaked at October 2007.

y-jun-06

January 2007 – Curve started inverting 2 mths back in Oct 2006

y-jan-07

June 2007 – all below 1 year ago, present slightly above 2-6mths ago. SPX has its last leg to the last peak at October 2007. Sudden spike in rates at front end of curve 2,3 mths ago around Jan-Apr 2007. False recovery from inversion at front curve and elevated  across all maturities. This hints its predictive value!

y-jun-07

January 2008 – Market fell to return all its gains from 2007. Present rates feel from 5% 6mths-1yr back to 2.5% as well as across maturities. 

y-jan-08

June 2008 – all rates remain suppressed below 5% with end of curve remaining strong and intact at 4.5% (affects long term asset management such as pension funds future payouts), but front part of curve all became squeezed below 3%

y-jun-08

January 2009 – Market crashed. Front end of curve feel to floor 0% and shows sign of inversion at further end of curve, where 30Y  receives 3% whereas 20Y receives 3.5%. Optimism about future is bleak… Market feels like there is no way out of the hole

y-jan-09

June 2009 – After ex-President Obama’s election, and a swift recovery from the final dive in SPX. Present curve remains higher than 2,3,6 mths ago but yet to recover former highs 1 year ago. All rates below 4%

y-jun-09-rally

January 2010 – Market managed to recover from its deep dive and loose monetary policies with QE1,2 that kept a 0-25bp rates corridor, made the curves steep the next 3 years. 

y-jan-10

January 2013 – Market recovered all its losses and SPX about to make new time high to break its 2007 peak. While curve are very steep, implying a expected growth in economy, long term rates are now 3%, below its 4% average it had from 2008-2010

y-jan-13

January 2014 – signs of flattening at end of curve as QE2 about to end at October 2014. Further end of curve managed to recover 3.5-4% yield. 

y-jan-14

January 2015 – QE3 resumed in October 2014, but market seems unamazed. Present curve flattens and SPX managed to fall and recover, maintaining a range state.

y-jan-15

June 2015 – SPX remains choppy, rates suppressed. Doubts of further QE

y-jun-15

January 2016 – market had a huge correction to new lows, but thereafter had a 3 months risk on state till April 2016. Hints from curves showed that further end is steepening. 

y-jan-16

June 2016 – slope remains same as 6mths ago, but levels went lower to below 2.5% as Fed did not managed to kept its promises to raise rates as forecast in its Dot Plots.

y-jun-16

 

January 2017 (Now) – Bond sold off caused a spike in front end of curve, while slope of further end remains same, but across maturities, rose above 2.5% for 20-30Y maturities. So will we get to see steepening of curves like in January 2013 with Trump around? While rates have raised from a expected pick up in industrial activities, future expectations as seen from the slope of the longer end curves (that prices in longer term catalysts) remain unchanged. Should the long end of the curve does not match the rise in short term yield, curve might become inverted. 

y-jan-17

Thanks for reading! Do keep out for the next analysis on which sector is the best to rotate into currently. One will surely ask, why not do some form of machine learning where recency of lookback is not as important as the similarity of curve slopes as well as other macro factors ? Factors that drive the bulk of cash flow and asset allocation in the world.

 

Breakdown of yield spread by maturities. Market is optimistic in the within next 5 years.

ts4.png

 

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