Safe Havens Coming Back In Style
Gwen Preston | Dec 11, 2018 13:29
Two big things happened last Dec. 4. The first big thing: U.S. markets fell significantly. The Dow Jones Industrial Average fell 700 points, or 3%, the NASDAQ lost almost 4% and the S&P somewhere near 3%. The sharp downturn followed a strong rally the day before fuelled by optimism that U.S. President Donald Trump and and Chinese Xi Jinping had agreed to a 90-day standdown in the two nations escalating trade dispute.
But the devil, as always, is in the details. And while everything about this trade war has been short on details, the two countries issued very different statements following the meeting – so the details we did get didn’t match up.
As the scale of the differences set in, Dec. 3’s market optimism turned to skepticism on Dec. 4 that Beijing would yield to U.S. demands any time soon. And fair enough. There are major issues that cannot be resolved, whether over a leaders’ dinner or within 90 days, including, but not limited to, intellectual property rights, Beijing’s subsidies to strategic industries, and Taiwan.
The lack of agreement was a stark reminder of how complicated and uncertain this trade war really is, and that got investors anxious. And so the markets skittered and slid down, while investors moved to safer areas – liked bonds and gold.
Let’s tackle those one at a time. Investors bought bonds, but preferred shorter duration notes to long-dated ones. And that matters, as it created the other ‘thing’ that happened on Dec. 4.
The second big thing: yields on 3- and 5-year Treasuries fell below those on 2-year notes. That means the bond market is collectively saying that rate hikes need to end, and soon.
In general, longer-dated bonds only yield less than shorter ones when investors see recession ahead. The reason is that investors pile into long-dated bonds when they are worried; since bond yields move opposite their price, all that buying drives yields down. When investors are confident they move out of long-dated bonds in favor of stocks; the selling pushes 10-year prices down and yields up.
That’s the basics of bonds: long-dated notes are the ones that matter in terms of investor confidence and they rise in price when confidence falls. Since bond yields move opposite their prices, 10-year yields fall when confidence falls.
Trends are great, but to compare periods we have to iron out the differences in interest rates, as they underlie bond yields. Enter the yield curve, which subtracts the yield on the 2-year Treasury (which is always just a bit above interest rates) from the yield on the 10-year Treasury.
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Whenever times are at all good – and investors expect times to remain good for a while – the yield curve is positive: the 10-year Treasury yields more than the 2-year. When things turn shaky, investors pile into 10-year notes, boosting the price and driving the 10-year yield down.
If things get shaky enough, the 10-year yield goes below the 2-year yield --> the yield curve goes negative or inverted.
Right now the difference is still positive, but only barely. In fact, the difference is the smallest it has been since January 2008, just before the financial crisis.
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