Last Week Today. The number of market-moving events was low last week, but there were two significant developments. Minutes from the January Fed meeting were dovish as expected, highlighted by a near unanimous decision to halt Quantitative Tightening (QT) by year-end. The pause in rate hikes and lower forecast QT have reconciled the Fed’s outlook and that of the market. | President Trump met with China’s top trade negotiator last week and, citing “substantial progress” in a trade deal, announced on Sunday afternoon that he would extend the tariff truce beyond the impending March 1st deadline.
In what has become a theme for 2019 (at least thus far), the Dow Jones Industrial Average and Nasdaq indices recorded their ninth consecutive week of gains, the longest winning streak since May 1995 (Dow Jones Market Data). Global equity markets joined in the bullish parade, and while developed international markets paced domestic markets with a gain of 0.7%, emerging markets led the way posting a 2.8% gain on the reduction in trade tensions.
It’s also worth noting that along with the impressive run in global equities, market-based measures of fear are melting. The VIX Index declined for the ninth straight week and, at 13.5, the volatility of S&P 500 Index options is less than half of its December peak (36.1). The MOVE Index (a measure of US Treasury bond volatility) has followed its equity-based cousin, declining from 68.3 to 47.2. Retail investor sentiment, as measured by the American Association of Individual Investors survey shows a distinct shift as well. Often referred to as a contrarian indicator, the percentage of Bullish investors doubled from 20% in mid-December to 39% last week, while the Bearish bunch has been cut in half from 49% to 25%. The market will require some good news to keep these trends going (e.g., continued progress in the trade deal with China or a reversal in the recent spate of weak economic data), but even then, it would be unwise to extrapolate the current pace of stock gains too far into the future.
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Q4 GDP Preview. On Thursday we will finally get a look at the Q4 GDP report, which has been delayed by the government shutdown. The Atlanta Fed’s GDPNow forecast for Q4 growth is looking anything but rosy, having fallen off a cliff after the abysmal December retail sales report. Last week’s weak durable goods report subtracted another 0.1% from the estimate, bringing Q4’s estimated real, annualized growth rate to 1.4% – well off the 3%+ average growth rate from the preceding three quarters and below the post-Financial Crisis trend growth rate of approximately 2%.
Having said that, the GDPNow forecast is highly volatile compared to the Blue Chip consensus GDP forecast owing to the forecast construction methodology. Whereas economists in the Blue Chip consensus estimates base their projections on anticipated growth rates for the entire quarter, the GDPNow forecast is “built” as actual data is released. The algorithm then extrapolates those data points to create a quarterly forecast. Hence surprises to the upside or the downside in key economic data releases during the quarter can whipsaw the forecast, as can be seen in the jagged green line in the chart below. As more data becomes available throughout the quarter, the forecast generally becomes more accurate.
What’s different this quarter is that the December Income and Consumption levels have not been released yet. With consumption making up roughly 70% of the economy, the lack of data in this key category renders the GDPNow forecast less reliable than it would otherwise be this late into the quarter. Even in periods without data release delays, the Atlanta Fed warns “..the forecasting error can still be substantial…” before the release of the GDP estimate. Suffice to say, Thursday’s actual GDP report will be watched closely for indications of whether growth is stabilized in December or deteriorated further.
The “Mendoza Line”. In Major League Baseball, a player that consistently hits below “200” (i.e., reaches base safely by putting the ball in play at least 2 out of every 10 opportunities at bat for a batting average of 0.200) is generally considered an offensive liability. No matter his defensive prowess*, the inability of a professional baseball player to consistently reach base is a harbinger to getting fired from a team. The term “Mendoza Line” originated in 1979 with Mario Mendoza of the Seattle Mariners. Mendoza had a history of poor performance at the plate, having hit below 0.200 in four of the five previous seasons. During an uncharacteristically slow start to the year, famed slugger George Brett’s teammates teased him “Hey, man, you’re going to sink down below the Mendoza Line if you’re not careful.” Brett shared the story with ESPN’s Chris Berman, and it stuck as a way to describe someone in a hitting slump.
Similar to a minimum batting average threshold in baseball that allows a player to remain in the major leagues, there are financial market metrics that serve as early indicators of economic growth troubles ahead. One such metric is the difference (aka, “spread”) between the yields on 10-year US Treasury and 3-month US Treasury bonds. When this spread has turned negative in the past, a recession has followed within twelve months on average. In the last 50 years, this simple parameter has predicted the previous seven recessions (the red shaded sections in the chart), with only one false positive.
Sources: Bloomberg and Covenant Investment Research.
This particular metric is so effective because it’s based on market participants’ assessment of whether Fed monetary policy is too tight. The Fed can control the front end of the curve through adjustments to the Federal Funds interest rate, but monetary policy doesn’t directly impact the yields of bonds that mature further in the future — those are set by investors buying and selling of bonds. Since the beginning of 2017 the Fed has raised interest rates eight times for a total of 2.00%. The yield on 3-month US Treasury bills has increased lockstep, rising from 0.47% to 2.40% over that period. Meanwhile, the yield on the 10-year bond began 2017 at 2.44% and currently stands at 2.65%, for a rise of roughly 0.20%, or 1/10 the amount of the increase in short-dated bond yields. The compression in the spread signals bondholders believe Fed monetary policy is getting too tight, leading to slower economic growth and continued inflation below the Fed’s target of 2.0% (inflation and associated higher interest rates is the most significant risk to US Treasury investments). Since economic growth and inflation are expected to remain low, investors are currently willing to accept a lower yield on their investment in longer-dated bonds.
As the chart highlights, the 10-year/3-month US Treasury Yield spread has been in decline since shortly after the Financial Crisis. However, it is only in the last year or so that the spread is reaching the critical threshold of going negative, i.e., falling below the “Economic Mendoza Line.”
Although the trend is concerning and is yet another data point indicating a deceleration of economic growth, it’s entirely possible that the spread widens out again. The Fed surely noticed the tightening yield curve spread, which contributed to their recent pivot from confidently hawkish to decidedly dovish. If the Fed’s rate hiking campaign has not already gone too far, or they cut rates soon, we may see the trend reverse as it did in the mid-1990s, a topic we will explore in Covenant’s upcoming Economic Review and Outlook. In the meantime, keep in mind that Mario Mendoza lasted in the Major Leagues for another couple of years after the term “Mendoza Line” became popular, and this economic expansion may not be done yet either.
* Pitchers, notably, are not held to any standard in batting as their value to a team is determined almost exclusively by the ability to get opponents out.