Australian Stock Market Apocalypse –Yield Inversion is bad news

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 It’s the question that puzzles pundits and experts alike, with
billion dollar hedge funds, mum & dad investors and everyone between
having a say and a stake in the answer.

Last Wednesday, Investors witnessed the worst trading day of 2019 & perhaps the most prescient indicator of an imminent recession, so it appears that the real question is actually when and not if.

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(Trading Economics – ASX 200 vs S&P 500 12/8/2019-16/8/2019)

 The orange line represents the S&P 500, whilst the Christmas coloured line is Australia’s ASX 200. Although the dips are most severe in the US market, it’s difficult not to notice the tight correlation between them.

The stock market has it’s own Book of Revelations, & the apocalyptic horseman is the yield differential between the 10 Year & the 2 Year US Treasury Bond. Treasury Bond’s are investments you can buy from the Government which give you a return in the form of coupon payments, which are like interest repayments on a mortgage.

The Government receives your cash upfront, and over the lifetime of the bond, you get your money back plus interest. So, the return (yield) on the 10 year bond is supposed to always be larger than its two year equivalent, because investors demand a higher rate of return on an investment that ties up their money for longer. The interest rate differential between the two is known as the ‘spread.’

(Federal Reserve Bank of St Louis)

 When the spread goes into negative territory, like it did on
Wednesday for the first time since 2007, the relationship has
‘inverted,’ meaning that investors are moving well away from ‘riskier’
assets, like shorter term bonds (e.g. 2 year bonds), and into longer
term ‘safer’ assets like 10 year treasuries. Longer term bonds typically
have a much lower default probability than their shorter term
counter-parts.

The inverted yield curve is so enthralling important because it has
successfully predicted all of the last seven major recessions going back
to 1969. The truth is, that whether you use the spread between the
10-year curve & the 2 year or 3 month bond, the inversion has never
boded well.

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(www.realinvestmentadvice.com – Negative Yield Spreads)

In the short term however, as JP Morgan’s Mark Kalanovic indicates,
things aren’t all bad, and you might even be able to make a bit of money
on the volatility,

 “Historically, equity markets tended to produce some of the
strongest returns in the months and quarters following an inversion.
Only after [around] 30 months does the S&P 500 return drop below
average.”

What investors and fund managers will now be looking at, is how
rapidly the curve ‘uninverts.’ It is the rapid positive growth of the
spread, as we see most clearly in 1981 and in 2007 that calls forth the
recession, whilst the inversion itself is typically the foreboding
background music.

AMP Capital chief economist Dr Shane Oliver says the “The risk of
recession in Australia is lower, probably 20 to 25 per cent,” whilst
contending that the probability of a near term US recession is slightly
higher, perhaps around 30% or so. S&P this week upgraded odds of a
US recession in the next 12 months to 30-35% per cent, up from 25-30%
per cent last quarter.

Some commentators have pointed to economic data, suggesting that
perhaps this time, the US economy is in much better shape than in
previous yield-inversion contexts. 

2007 2019 (Current)
Annualised Real Personal Income Growth 1.4% 5%
Annualized Employment Growth 0.8% 2.6%
Annualised industrial production Growth 2.2% 4.8%
Annualized Real personal Consumption Expenditure Growth 4.6% 11.5%
Annualized growth in real wages 5.7% 13.4%
Annualized GDP 2% 4.8%

(RealInvestmentAdvice.com)

However, the onset in 2008 from the inversion was so rapid, it is difficult to regard any kind of complacency without suspicion.

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(10 Year vs 2 Year Interest Rate Spread)

 When the recession hits the US, Australia will follow shortly
afterwards. With such a heavy inter-market dependence, & commodity
prices far lower now than in 2008 and the depths of the GFC, Australia
can’t rely on precious metals to prevent a contraction.

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International Monetary Fund, Global Price Index of All Commodities
[PALLFNFINDEXQ], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/PALLFNFINDEXQ, August 18, 2019.

And the bad news keeps on coming unfortunately, as we’ve all but run
out of monetary options. RBA Governor Phillip Lowe has indirectly
admitted what many ‘fringe’/Austrian economists have ruminated for some
time, that central banks solve very little, and have  almost no ability
to prevent recessions. With the official cash rate sitting at 1%, Lowe
recently told the parliamentary economics committee “it’s possible we
end up at the zero lower bound although I think it’s unlikely.” To be
pontificating over introducing near-negative interest rates in a period
of non-recession suggests to the critical observer, that Lowe is not
only flogging a dead horse, but that the whip never worked in the first
place.

 For the Austrian’s among us there may be some kind of silver lining,
as a contraction may bring about a renewed focus on the role and
efficacy of the central banks. Murray Rothbard’s ‘Case Against the Fed’
is perhaps the best explanation of why Central Bank’s can’t solve
underlying structural issues & in fact make everything a whole lot
worse.

 What’s absolutely apparent, irrespective of your opinion on Rothbard or Central Banks in general, is that an American plunge leads to an Australian dive, and if the yield curve is even slightly reliable, there will be no escaping the contraction this time. Watch for safe-haven assets like Gold and bitcoin to surge in the next few months, as the capital tries to protect itself from the invariable contagion effect, that almost always follows the inversion.

Alexander Cameron is a Host on the Carnage House Productions Show. This article originally appeared on their website.

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