The title is a Latin phrase that effectively states, “after this, therefore because of this.” Succinctly, the reasoning that since event X followed event Y, then event X must have been caused by event Y. This informal fallacy is rooted in the belief that correlation is causation, consequently a conclusion based solely on the order of events may inadvertently rule-out other factors that conceivably and logically could be responsible for the result, and in effect rule out the connection all together. The most common and simplest example used to demonstrate this fallacy is, “the rooster crows immediately before sunrise; therefore, the rooster causes the sun to rise.”
This month’s writing is not intended to be a Latin dissertation, nor a philosophical debate on causality. Rather, a recent event, which has been both feared and somewhat expected in many corners, simply has me thinking about what may lie down the road. The event: an inversion of the yield curve (when short-term rates are higher than long-term rates), as depicted by the 2-year Treasury moving higher than the stated yield on the 10-year Treasury. Technically, the yield curve has been inverted for some time now, as the 3-month Treasury elevated past the 10-year Treasury yield in March, reverted back for a short period, and then inverted again in May. The negative spread between the two now measures roughly 40 basis points.
It is, however, this closely watched relationship between the 2-year and 10-year notes that economists peg as a relative indicator of both current and expected conditions in the economy. An “inversion” of the yields on these Treasuries has effectively presaged the last five recessions in the United States, as reflected on the graph below. If the graph were extended to 1955 then this indicator would have captured the last nine economic downturns, while only once, in the mid-1960’s, did this occurrence fail to result in an officially-defined recession (although an economic slowdown did take place). This past Wednesday, in part driven by a flight to safety in the bond market as geopolitical volatility continued to increase while uncertainty relating to ongoing trade wars escalated, the bond market effectively drove the yield on the 10-year Treasury below 1.6% and resulted in the first inversion of this metric since late 2007:
The historical precedent over the last 50 years is daunting. Last month, the title of our piece now seems both apt, and while not necessarily prescient, definitely appropriate in light of recent events: Uncertain, Volatile, Unsettled: Get Used To It. During the past few weeks, the gyrations in the stock market have been somewhat anxiety-inducing. Trade tensions with China mount, and the Dow sells off 750 points. Tariffs are put in a bit of a holding pattern, and the Dow rebounds 400 points. In just the last eight trading sessions, the Dow has been down 750, up 300, flat, up 375, down 100, down 400, up 400…and then, with the aforementioned yield curve inversion, a sell-off resulting in an 800-point drop.
The Fed is empowered to set interest rates based upon its assessment of inflation and employment. Today, that mandate appears to be challenged, if not outright confusing. Candidly, introducing economic stimulus in the tenth year of a record economic expansion, by virtue of a “mid-cycle adjustment” as the Fed framed it, seemed a bit perplexing. With the proliferation of cable news channels and powerful search engines like Google, we now have a population of millions of “financial experts” ready and willing to opine on the implications of this inversion. So, while I majored in economics during my undergraduate years, I’ll politely step aside and try to take a soberer view of this occurrence and truly rely on those that have spent a lifetime studying these things to coherently articulate their thoughts.
Inflation is tame, by all measures. Unemployment rates are at 50-year lows. However, there are emerging headwinds that should be monitored. Weaker global growth (most recently in China and Germany), uncertainty surrounding Brexit, a sharp increase in market volatility that began in late 2018 (although muted for much of 2019, before re-emerging of late), continued unknowns in terms of the potential implications of trade tariffs, possible shifts in the Fed’s balance sheet as it gauges economic stability, an annual budget deficit approaching $1 trillion which would feed an already $20+ trillion level of Federal debt, negative yields in Europe, the potential implications as the yield on the 30-year U.S. Treasury recently touched an all-time low of approximately 2%, and a continuing sense of political dysfunction on both sides of the aisle leading-up to the 2020 election, to name just a few.
Interestingly, one year ago at this time the markets were moving with the expectations of continued rate increases at the Fed through 2019 and probably into 2020. However, at the start of the year, sentiment shifted in a meaningful way as the Fed communicated it would be “patient” and “data dependent”, thus putting its intended methodical tightening program on hold. And just last month, Fed policy was dramatically altered yet again with a quarter-point rate cut and somewhat mixed signals with regard to the possibility of additional easing.
Jamie Dimon, Chairman and CEO of JPMorgan Chase, is fond of saying something along the lines of, “you can’t run your business hoping there won’t be a recession.” Economic cycles are inevitable, if not predictable timing-wise. The unknowns are the depth, breadth, and length of these downturns. I’m simply hoping that the next slowdown will be modest and short-lived. But that slowdown is on the horizon, and it may in part be a classic self-fulfilling prophecy. If we talk about it enough, and condition our behavior on both the consumer and business fronts in anticipation that it may be just around the corner, then most assuredly things will slow down.
And that is not to say that expansions are doomed to die of old age. There may very well be quite a bit of runway left in this economic cycle. While the current expansion is now more than twice as long as the approximate 5-year average recorded in the U.S. since the end of World War II, it is still quite a bit shy of the roughly 16-year expansion witnessed by Great Britain through most of the ‘90s and into the ‘00s (before ending with the Global Financial Crisis in 2008). And it is virtually still in its infancy when measured against Australia’s nearly 28-year streak that began in the early ‘90s and continues, albeit challenged, today.
Maintain underwriting integrity and discipline. Manage capital and reserves carefully. Emphasize sound risk management practices and a robust architecture. You are stewards of your shareholders’ investment. Do not succumb to the “this time is different” mindset. There are always nuances and shifting parameters as our economy has shifted over the past few centuries from predominantly agrarian-driven, to mainly industrial-powered, and now largely technology-fueled. The constant, for successful banks, has been adhering to solid credit standards and sound cost controls. I am reminded of when I first started in banking, coming out of the vaunted training program at The Bank of New York and “graduating” to a line lending position within the corporate metropolitan banking division. Early in my career, a bit full of myself after helping to secure a sizable revolving credit facility with a New England-based Fortune 500 company, I was quickly brought back to reality by the Bank’s sage and seasoned Chief Credit Officer. He took note of my temporarily insufferable self-congratulatory disposition, and simply said, “Any idiot can make a loan, Moran…we PAY you to make sure we get the money back.”
Historically, as reflected on the graph, recessions in the U.S. have arrived typically within 12-24 months of the 2yr/10yr inverting. Full employment and a lack (thus far) of traditional inflationary pressures, seem to currently be counter-balanced by uncertainty on the geopolitical front and the potential unintended consequences of ongoing trade wars. With the record economic expansion now extending beyond ten years and marking the longest such stretch in recorded history (while including what is now approximately 105 consecutive months of job gains), the question remains: how much longer can/will this continue?
In closing, attached please find our monthly summary of Michigan’s financial institutions. As you and your Board take your organization forward, please do not hesitate to reach out to me and/or my colleagues at ProBank Austin if we can be of any assistance in helping you assess the competitive landscape. My best wishes for continued success as you move through 2019.
AUGUST 2019 MICHIGAN BANKING SUMMARY
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