02 May Canaries in the Coal Mine
In our last update, we noted that the theme of 2018 was to be coordinated global growth. In the past quarter, however, three indicators have caused us to become more cautious more quickly due to the increased likelihood of a correction or worse: increased volatility, a flattening yield curve and the ballooning federal deficit.
Volatility has historically risen near the end of a protracted expansionary cycle and often serves as a warning sign of a bear market. The S&P 500 Index has already experienced daily moves of more than 1% (either positive or negative) than it experienced in all of 2017. At the current pace, 2018 would experience 92 days of these 1% moves. This figure is elevated compared to recent averages and would be the most 1% days in the last several years, as illustrated below.
As we explained in our 2018 Global Economic Outlook and Asset Class Assumptions presentation (available upon request), market volatility tends to be low during extended expansionary periods of an economic cycle. In the current cycle, January of 2018 marked the 107thmonth of expansion since the 2009 market bottom, which is almost three times as long as the average duration of 41 months. The recent uptick in volatility may be temporary, but it may also be a warning sign that post-crisis bull market is coming to an end.
FLATTENING YIELD CURVE
In an expansionary period, the yield curve is usually upward sloping, meaning that yields on the “long end” of the curve (longer maturities) are greater than on the “short end” (shorter maturities). This environment indicates that interest rates are expected to rise as a result of normal inflationary pressures resulting from a growing economy. Recessions, however, are often preceded by a flattening yield curve, when the yield for all maturities is roughly the same, or an inverted yield curve, when yields on the short end are greater than yields on the long end. An inverted yield curve usually indicates that interest rates will likely fall in the future as a result of an economy in contraction or recession, lacking inflationary pressure.
A flattening yield curve can be measured by the difference in yields between 2-year and 10-year US Treasury bond yields (the 2/10 spread). When the difference in the 2/10 spread nears zero, the yield curve is flattening. A negative 2/10 spread is a strong indicator that the yield curve is inverting.