Tag: yield curve

The Cyclical and the Secular

 

“By searching the sky now, me and other asteroid hunters hope to give us the early warning – ideally decades – that we need. But that strategy of focused searching hasn’t stopped people from thinking about what we might do if an asteroid was on its way toward us.” ― Carrie Nugent

This week’s piece is both a bit short and important. In the second half of the piece, we share a critical identity in understanding the fundamental drivers of the US yield curve.

 

We have put in much time and thought into better understanding the economic fundamentals driving the yield curve and put forth a seemingly straightforward identity that, we hope, can better explain shifts in the yield curve.

 

OECD Leading Indicators and the Cyclical Trend

 

The below chart is that of the year-over-year change in the OECD Leading Indicator Index for major economies and that of the yield on the US 10-year Treasury bonds lagged by 3 months.

 

OECD LI vs 10Y Yield

 

The leading indicators index tends to lead long-term yields by, approximately, three months.

 

In 2018, long-term yields over shot to the upside based on the leading indicators index. Today, the index is signaling that yields are too low and on a cyclical basis economic activity in the major economies has bottomed and is turning up.

 

The below chart is that of the leading indicators index versus the the MSCI All Cap World Index excluding US stocks lagged by nine months. Global stocks, excluding the US, tend to lag the leading indicators index  by six to nine months.

 

ACWI ex Us vs OECD LI.png

 

The leading indicators index suggests that non-US stocks are close to bottoming on a cyclical basis.

 

The Secular Trend Behind the Yield Curve

 

In the below chart, the orange line is the 10Y – 2Y US Treasury yield curve and the magenta line represents US private savings less US private investment.

 

US Savings Less Investment vs Yield Curve.png

 

Private savings less private investment approximates the shape of the yield. Given, however, the fractional reserve system of banking, the private savings surplus or deficit has some slippage that does not capture excess credit creation by the banking system. Nonetheless, it is a good enough proxy for the purposes of approximating the direction of the yield curve.

 

What does a private savings surplus or deficit have to do with yield curve?

 

At the start of an economic expansion, private savings are plentiful, having been replenished following a recession as households and corporations repair their balance sheets by increasing savings and scaling back investments. As private sector balance sheets are repaired, confidence slowly returns and a new investment cycle commences.

 

With plentiful savings, in the form of deposits and cash like holdings, short-term interest rates are pressured lower. Reduced appetite to invest in longer maturity assets following a recession pushes up longer-term interest rates to entice savers to invest in longer duration assets. With an upward sloping yield curve, the banking system is incentivised to undertake maturity transformation by borrowing short and lending long.

 

As savings are drawn down, the declining supply of capital at the short end of the yield curve places upward pressure on short-term interest rates. At the same time as capital moves towards longer duration assets, the increased supply pushes down interest rates at the long-end. The continued maturity transformation undertaken by banks by borrowing short and lending long eventually leads to a flattening of the yield curve.

 

The yield curve inverts when increasing investments have exhausted private sector savings and the competition for marginal capital available at the short-end pushes up short-term interest rates.

 

The yield curve eventually steepens as appetite for longer duration investments collapses and an increasing number of investments made during the expansion become impaired. Impairments are caused by (1) investments no longer being profitable (on a net present value basis) due to the higher short-term rates; or (2) revelations of misallocation of capital into speculative or ponzi investments that sustained only because of the abundance of capital.

 

The drop in capital investments precipitates a recession and the economy once again has to enter a phase of balance sheet repair before the economy re-enter an expansionary phase.

 

Economic Identities

 

(1) GDP (Y) = Consumption (C) + Government Spending (G) + Investment (I) + Exports (EX) – Imports (IM)

 

(2) Y – C – Tax (T) = G – T + I +  EX – IM

 

(3) Private Savings (PS) = Y – C – T.

 

(4) PS = G – T + I + EX – IM

 

Current Account (CA) = EX – IM

 

(5) Savings of the Government (SG) = T – G

 

(6) PS = I + CA – SG

 

Putting It Altogether

 

Private sector savings in the US can be replenished by (1) increased foreign investment into the US, (2) the current account going from a deficit to a surplus or (3) the government increasing its spending.

 

If we assume, the current account deficit remains around current levels, private savings will only be replenished through increased (foreign) investment or increased government spending.

 

Loosely, government spending and foreign investment are two sides of the same coin. The US has historically financed its fiscal deficits with the capital foreigners have invested in US Treasury securities. Foreign investors, however, may be unable or unwilling to finance the US government for a wide variety of reasons including:

 

(1) a US dollar shortage leading to stress or turmoil in their local economies;

(2) protectionist policies of the Trump Administration; or

(3) the unfavourable risk-to-reward profile of financing ever increasing deficits at record low interest rates.

 

If all foreign investors want or need is higher carry, the yield curve will simply steepen as it has done in the past. In the no-longer remote chance that foreigners are unable or unwilling to finance growing US deficits for reasons other than  higher carry, however, what then is the release valve that will enable private sector savings to be replenished?

 

Should we be surprised that modern monetary theory (MMT) has become part of the broader economic policy discussions and no longer a fringe theory?

 

MMT is a whole other can of worms and deserves a discussion on its own that we will return to at a more opportune time.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Late Cycle Signals and Yield Curve Dynamics

 

“Everything turns in circles and spirals with the cosmic heart until infinity. Everything has a vibration that spirals inward or outward — and everything turns together in the same direction at the same time. This vibration keeps going: it becomes born and expands or closes and destructs — only to repeat the cycle again in opposite current. Like a lotus, it opens or closes, dies and is born again. Such is also the story of the sun and moon, of me and you. Nothing truly dies. All energy simply transforms.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

 

“We say that flowers return every spring, but that is a lie. It is true that the world is renewed. It is also true that that renewal comes at a price, for even if the flower grows from an ancient vine, the flowers of spring are themselves new to the world, untried and untested.

 

The flower that wilted last year is gone. Petals once fallen are fallen forever. Flowers do not return in the spring, rather they are replaced. It is in this difference between returned and replaced that the price of renewal is paid.

 

And as it is for spring flowers, so it is for us.” – The Price of Spring by Daniel Abraham

 

“There are constant cycles in history. There is loss, but it is always followed by regeneration. The tales of our elders who remember such cycles are very important to us now.” – Carmen Agra Deedy

 

Late Cycle Signals

 

Each business cycle is unique. Certain patterns, however, have tended to repeat across business cycles with the ebbs and flows in the level of economic activity.

The late stage of the business cycle is often characterised by an overheated economy, restrictive monetary policy, tight credit markets, low unemployment rates and peaking corporate profit margins.  These are not the types of signals that form part of our discussion on the late cycle this week. Instead we focus on behavioural clues from the financial services and investment management sector that signal that we may have potentially entered the late stage of the business cycle – often the most rewarding, but also the most precarious, phase of bull market for investors.

 

1. Liquidity events for investors in ride hailing services companies

 

Few opportunities have captured the imagination of venture capital investors over the last decade as the one represented by ride hailing services companies such as Uber, Lyft, Didi Chuxing and Grab.

 

 

 

  • Didi Chuxing, China’s equivalent to Uber and valued at US dollars 56 billion during its last fundraising, is the most valuable start-up on the Mainland and counts Apple, Softbank and Uber amongst its shareholders. The start-up is estimated to have raised US dollars 20.6 billion in funding over 17 rounds of financing.

 

  • Southeast Asia’s leading ride hailing services company, Grab, was valued at over US dollars 10 billion in a fundraising round in June this year and has received US dollars 1 billion in funding from Toyota.

 

With such eye-popping valuations it should come as no surprise that most, if not all, of the leading ride hailing companies the world over are weighing up potential liquidity events, be it an initial public offering or a trade sale to larger competitors or strategic investors. The investors in these companies are undoubtedly eager to convert their paper profits into realised gains in the form of cold hard cash.

 

  • Lyft has hired JP Morgan to lead its IPO and is aiming to beat its much larger rival, Uber, in becoming the first ride hailing services company to be publicly listed

 

  • Uber has reportedly received proposals from Wall Street valuing the company as high as US dollars 120 billion – almost 67 per cent higher than the valuation at its last round of fundraising

 

  • Didi Chuxing is reportedly weighing up the possibility of a public offering in 2019

 

  • Careem Networks, the Middle East’s leading ride hailing services company, and Uber are rumoured to be in talks for a possible merger or an outright acquisition of the Middle Eastern business by Uber. Careem was valued at US dollars 1 billion during a fundraising round in December 2016. Bloomberg reported in September that the acquisition of Careem by Uber would value it between US dollars 2 to 2.5 billion – a 100 to 150 per cent increase in less than 24 months.

 

In 2007, The Blackstone Group, the leading alternative asset management firm, successfully listed on the New York Stock Exchange, selling a 12.3 per cent stake in return for  US dollars 4.13 billion. Blackstone’s listing was, at the time, the largest US IPO since 2002.

Although Blackstone was able to successfully list, many of its rivals – including Apollo Global Management, Kohlberg Kravis & Roberts and the Carlyle Group – missed the opportunity to float ahead of the global financial crisis and had to shelve their plans and wait for a more conducive environment.

We worry that a similar fate awaits the riding hailing services industry, where it becomes a case of one IPO and done and the remaining companies’ plans are delayed by an abrupt end to the current iteration of the US equity bull market.

 

 

2. INVESCO to buy OppenheimerFunds

 

INVESCO, the independent investment company headquartered in Atlanta, Georgia, this week agreed to buy rival Massachusetts Mutual Life Insurance’s OppenheimerFunds unit for US dollars 5.7 billion. According to the Wall Street Journal:

“Invesco will pay for the deal with 81.9 million common shares and another $4 billion in preferred shares, making MassMutual the firm’s largest stockholder. Including OppenheimerFunds, Invesco will manage more than $1.2 trillion in assets.”

In the summer of 2009, BlackRock acquired Barclays Global Investors, including its highly coveted iShares franchise, for US dollars 13.5 billion and created a combined entity with, at the time, approximately US dollars 2.7 trillion of assets under management.

BlackRock’s timing was impeccable: a near decade long equity bull market ensued and, even more importantly for BlackRock, the company put itself in the prime position to reap the rewards of the rise of passive investing.

The rationale for the OppenheimerFunds acquisition according to the Wall Street Journal paraphrasing INVESCO CEO Martin Flanagan is to: “strengthen Invesco’s position in some businesses that have been proven resilient to the move toward passive investing, including international and emerging-markets stock funds.”

We are curious to see if INVESCO’s decision today turns out to be as flawed as BlackRock’s decision in 2009 was impeccable.

 

3. Middle market alternative asset managers selling stakes

 

In recent years, seemingly successful, mid-sized alternative asset management firms have started selling equity stakes to their much larger, more established competitors such as Neuberger Berman, The Blackstone Group and the Carlyle Group.

Dyal Capital, a unit of Neuberger Berman, has closed 30 or more transactions acquiring stakes in alternative asset managers over the last 2 to 3 years, including a strategic investment into Silver Lake Partners. Dyal presently manages three funds with US dollars 9 billion in assets under management and is set to complete fundraising over 5 billion for a fourth fund.

The most recent of such sales comes from New Mountain Capital, which manages private equity, public equity and credit funds with more than US dollars 20 billion in assets under management. The company has reportedly sold a 9 per cent stake to Blackstone Strategic Capital Holdings.

We wonder: what are the chances that highly successful private equity and alternative investment firms would sell their stakes at anything but close to peak valuations?

 

Yield Curve Dynamics

 

Given that we have discussed late cycle signals above, we wanted to touch upon the historical dynamics of the Treasury yield curve when it has either gone (i) from inverted to flat or (ii) from flat to positively slopping.

Prior to sharing our findings, we wanted to share some analysis for the period starting 1959 and ending 1984 from Interest Rates, the Markets, and the New Financial World (1985) by Henry Kaufman:

 

“If the risk in investing in the long market is still great immediately following the point of maximum inversion, when does the long market offer the best opportunity? To answer this question, it is necessary to examine the swings in the U.S. Government securities yield curve during the past quarter century.

These swings are:

 

  1. from extreme negative (short rates above long) to flat
  2. from flat to extreme positive (long rates above short)
  3. from extreme positive to flat
  4. from flat to extreme negative

 

The results are as follows:

 

1. When the yield curve for government securities swung from extreme negative to flat, long yields actually increased with one exception – the 1980 cycle. In one of these cycles, there was greater rise in long yields than in short rates. In all other instances, however, short rates fell while long yields rose.

 

2. When the yield curve moved from flat to extreme positive, with long yields going above short, in all cycles long yields fell in conjunction with a more sizable drop in short rates.

 

3. The swing from extreme positive to flat can be quite dangerous in the long bond sector. In the four complete cycles… yield increases average 104 basis points for long-term issues, ranging from 40 to 220 basis points.

 

4. The most dangerous period of all for investors in long bonds, however, occurs when the yield curve moves from flat to extremely negative, with short rates moving up above long.”

 

Interestingly, the period around the time of publishing of Mr Kaufman’s book was the exception for how the long end of the curve reacted when the yield curve went from extreme negative to flat. And Mr Kaufman speculated in his book if the long-running bond bear market was over or not. With the benefit of hindsight we know that the bond bear market had indeed ended during the early 1980s.

For the period from 1980 till date and with respect to cycles where the yield curve went either (i) from inverted to flat or (ii) from flat to positively slopping, we make the following observations (based on the yield differential between 2 and 10 year Treasury securities):

 

  1. 1980 – 1982: the yield curve went from extreme negative to flat with both short and long rates declining. Short rates declined faster than long rates.

 

  1. 1988 – 1992: from flat to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

 

  1. 2000 – 2003: from inverted to flat and then to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

 

  1. 2005 – 2010: from flat to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

 

In recent weeks we have witnessed the yield curve correct its flattening trend due to a sell-off at the long-end. The yield curve has steepened due to higher long-term yields – a phenomena last witnessed in the 1970s. These are still early days and the recent sell-off at the long-end may be nothing more than a blip. If, however, the yield curve continues to steepen due to increasing long-term yields it would be an ominous sign for bond bulls.

Much like Mr Kaufman speculated that the bond bear market may have ended in the early 1980s, the recent shifts in the Treasury yield curve and the forthcoming supply of US Treasury securities have us wondering if the multi-decade bond bull market is over.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.