The Fed's New Role as Spoiler

​Surprisingly the great bubble builders of the past 8 years (the Global Central Banks) are now trying to pump the brakes and quite honestly seem to be ignoring the soft economic and declining corporate earnings data globally.
 
The Federal Reserve (and for that matter the other major Central Banks across the globe) seem to be scrambling for the proverbial door.

Each seems bent on raising the interest rate they charge their member banks, lessening their asset buying programs and/or even reducing their balance sheet holdings as if scrambling to have ammunition to fight the next economic downturn.
 
Our own Federal Reserve is the lead provocateur.  They have already raised their reserve rate four times since 2015.  They have likewise broadcast a series of future interest rate increases that will last through 2018.  Most importantly they have announced their intention to reduce their $4.2 trillion balance sheet holdings in U.S. debt securities, but have yet to lay out any specific timetable.  

​This to us seems crazy given the lackluster GDP growth and weakening corporate data. 
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Why on earth would you be tightening into a weakening economic cycle? 
 
That is unless you were trying to get some ammunition for the next economic downturn or have political motivations to saddle the current sitting President with an economic slowdown, which for an apolitical agency would seem improbable.
 
You can clearly see what the markets believe, below, as most fund flows have been into cyclical, defensive and bond proxy sectors since January.  This tends to reinforce the idea that market participants are either 1) nervous about the markets, 2) see weakening GDP and corporate data leading to a cycle end, and/or 3) believe the Fed is incorrect in raising rates or that they will ultimately not be able to raise rates as future economic data weakens. ​

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​The Fed is not alone as there is talk of pulling back on equity/debt buying programs in both the Eurozone by the ECB and in Japan by the BOJ.
 
What has this done then to the bond markets?  It has made a confused mess of those markets.
 
On the one hand, you have market participants who are watching the economic data and seeing weakness.  This was reflected in falling long-term interest rates (until just a few days ago).
 
Then you have the Federal Reserve raising rates on the short end of the yield curve. 
 
The resulting mess is a flattening of the interest rate yield curve as shown below in this relative performance chart of the 2-year Treasury divided by the 10-year Treasury yield.  In English, this chart shows rising short-term rates relative to longer-term rates which are generally higher due to greater long-term growth expectations.  The rising short-term rates leads to a flattening of the interest rate yield curves as the interest rate differential between them shrinks.

If we go back further in history we can see that whenever yields flatten and then rates actually invert, where short term rates are higher than longer term rates, an economic recession is almost guaranteed.
 
Check out this chart my good friend Leo Cesna provide me (top of next page)!
 
What we see in this chart is that when yields on the 1, 2, 5, 10, 20 and 30 year treasuries converge, an economic recession has occurred.  Maybe not immediately, but sometime during that convergence.

You can clearly see on the right side of this chart that rates are again headed for a conversion that may again spell an economic recession and likely a market decline.
 
The moral to this story could be that you should enjoy the possible continued rise in the markets over the next 6-8 months, but be preparing for the possible economic downturn that may follow.  More on that in our next blog post.
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