Noise and substance

2019 has so far proven another good year for the financial markets. Since the big financial crisis of 2008 markets have moved most of the time up. This is in spite of a macro environment with considerable tensions and headlines which generate renewed market concerns regularly. Chief among those concerns is the trade war between the US and China. A tweet of President Trump is enough to move markets up or down depending on whether it suggests a hardening of the positions or a possible return to the negotiation table.

In addition, other concerns have been ongoing for the last couple of years among investors including elevated valuations levels by historical standards and the fact that after ten years of expansion in the global economy the risk of a cyclical downturn is increasing every day. Of course the geopolitical hotspots of North Korea and Iran have been on the mind of investors as well as the slowdown of the Chinese economy, the Brexit that seems to drag-on forever with no resolution in sight and further issues as well.

News related to such issues have impacted markets only over short-term periods varying between a few hours, a few days or a few months. Overall the trend has been up. The cause of that uptrend is clearly recognized as the accommodating policies of the global central banks that have all used a range of tools aimed at supporting the markets and the real economy. While the impact on the real economy is a complex matter which is hard to evaluate the impact on financial markets is clear. Increasingly lower interest rates have resulted in increasingly higher asset valuations for all asset classes as investors were increasingly incentivized to move away from cash. 

Historically interest rates have always been a key driver of financial markets. The continuous fall in interest rates over the last three decades has been a major factor behind the strong performance of financial markets during this time notwithstanding the big financial crisis. International conflicts and major political tensions both within and between nations do not usually have a major, lasting impact on the financial markets. Interest rates represent the real story and the substance behind the tectonic shifts affecting financial markets.

How interest rates move and what affects them is probably beyond the current grasp of even the most insightful economist. From a practical point of view they are cyclical. With rates at historic lows, close to or even below zero, some of the most successful fixed income investors have thought over one year ago that a turning point had been reached and that rates could not go much lower. However, after a short rebound, US rates are back to historic lows. But by international standards they are comparatively high. While no one knows with certainty where they will go, the legendary former chief of the US Fed, Alan Greenspan now believes that it is only a matter of time before US rates go negative 1. Others also think so 2.

If interest rates continue to go down this will act as further fuel to asset prices. On the other side in the event that the trend turns again many of the recent gains will be reversed and there is potential for significant losses.

In the current environment investors are walking on eggs. With the uncertainty affecting further evolution in interest rates and market moves it makes sense, especially for the risk-averse investor, to allocate a significant part of his portfolio to investments that are less correlated to the financial markets and likely to generate positive returns independently of market conditions. This can be achieved by lowering the exposure to the traditional stocks and bonds portfolios and increasing the exposure to alternative assets such as first-rate hedge-funds, private equity and venture capital, alternative finance and direct investments. 

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1. Alan Greenspan says it’s ‘only a matter of time’ before negative rates spread to the US

2. "Why US bond yields could be going the way of Germany and Japan"

The Yield Curve: Predicting a Recession?

On March 27, 2019 the US Yield Curve inversed. More precisely the spread between the 10- years and the 3-months Treasuries. This event generated many alarming headlines and is significant. The yield curve is one of the most closely followed economic indicators and for good reason. It has historically been one of the best predictors of upcoming recessions.

The concept of the Yield Curve

Prior to analysing the issue, let’s consider the meaning of the yield curve. Simplifying slightly, the yield curve notion is simple: it is the difference between the short term and the long term interest rates. Usually, long-term interest rates are higher than short term rates. 

The reason for the premium investors require to invest into longer dated bond is primarily due to the uncertainty regarding future levels of inflation. While there is usually good visibility on short term inflation, there is considerable uncertainty regarding the level of long term inflation and therefore it makes sense for investors to require a higher rate.

However, there are instances, relatively rare, where the long term interest rate is lower than the short term interest rate – in such a case, the yield curve has inversed. The likeliest explanation for such a situation is that investors are quite gloomy about the economic outlook, and assume that the weak economy will force the central bank to lower interest rates considerably going forward. 

What will happen?

While there are many economic indicators that reflect market expectations regarding future economic developments none of them comes close to the inversed yield curve in terms of their effectiveness as a leading economic indicator. In the last forty years the yield curve inverted five times and was followed by a recession every time1. Since 1960, the yield curve inversions predicted eight out of the nice recessions 2. Typically the time lag between the inversion and the recession was 18 months3. Every recession brought with it a significant market correction. 

With such a powerful indicator negative, does it mean that a recession and a major market correction are imminent? “This time is different” is an often heard expression in financial markets but financial history tends to repeat itself. Nevertheless we believe that there are a number of important points to consider and that this time might really be different.

Firstly, usually at the turning point before a recession real rates are high and credit quality starts worsening with widening credit spreads. At present current real rates are near zero versus 3% prior to the past 6 recessions.4This is a significant difference.

Secondly, the spread between the US 10-years Treasury and the German government Bund is 250 bps which is close to the top of the range for the last 30 years. In other words, the low interest rates in the US is also influenced by the very low rates in Germany and other major economies outside the US.4

Thirdly, so far it is only the 3 months to the 10 years spread that turned negative while the 2 years to the 10 years spread has so far not inversed and has historically been a more significant leading indicator.3 

Fourthly, the credit curve on corporate bonds is far from having inversed: “The difference in the credit spread between short- and long-dated U.S. corporate bonds is around 120 basis points, well above its average of 80 basis points since 2000. That spread difference last inverted in March 2008, about five months before the financial crisis”.5

Fifthly, when considering the current situation one has also to remember that over the last decade interest rates have been impacted by policy decisions of the central banks in an extreme way that has no historic precedent. This creates distortions which are making past history less relevant in understanding the current situation.

In summary there are good reasons to believe that this time might be different. However, one should not dismiss the inversion of the 3-months to the 10 years Treasuries outright. The fact that it was driven by a drop in the real long term interest rates is worrying in and for itself as it implies weak macro expectations on the side of credit investors. The current yield curve structure also makes it harder for banks to make money by hurting their lending profit margins.2

With high employment, overall solid US macro data and the improvement in China, it seems in our view overall likely that a recession is not imminent despite the inversion.


An inversion of the spread between the 2-years and 10-years Treasuries or an inversion of the corporate credit curve could be more powerful signals of an upcoming recessions and should therefore be closely monitored. In such a case, risk should be minimized very fast.

Conservative investors should in our view continue to be defensive and rather err on the side of caution. 

Beyond any practical implications, we hope that this paper makes clear to which extent markets are complex. Nobody can predict them reliably, the best one can do is to manage risks in order to achieve an optimized long-term performance with a controlled risk level. 

Orit Raviv Swery                                                    Ilan Weil

Founder & CEO                                                     Chief Investment Officer












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