Cash is better than U.S. stocks for the first time in a decade — and that has some people worried

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JONATHAN RATNER Updated: July 23, 2018

Cash is better than U.S. stocks for the first time in a decade — and that has some people worried

Rising short-term bond yields and the flattening curve is classic late-cycle action and raises the risk of a recession

The yield on three-month U.S. Treasuries recently climbed above two per cent — something not seen in more than 10 years — and it has doubled since August 2017. FILES

Cash is offering a higher yield than U.S. stocks for the first time in a decade, providing investors with yet another reason to lighten up on equities.

The yield on three-month U.S. Treasuries recently climbed above two per cent — something not seen in more than 10 years — and it has doubled since August 2017.

The money market has undergone a coronaryDavid Rosenberg
As a result, this cash-equivalent liquid asset now offers investors a premium to the S&P 500 dividend yield of about 1.85 per cent, without having to take on capital and duration risks.

“The money market has undergone a coronary — and this hits other markets and the economy with lags,” said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc.

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A quick glance at the chart for three-month Treasury yields, which were close to zero as recently as the end of 2015, makes it difficult to believe we’re not in a new era of sharply higher short-term interest rates.

“Whether or not this is recognized by the masses at the current time, those still playing by the old rules, matters not,” Rosenberg said in his daily report.

Rising short-term bond yields, and the resulting flattening of the yield curve, also raises the risk of a recession.

The curve, which measures the difference (term premium) between yields at various maturities, has narrowed to 0.25 percentage points for two- and 10-year notes, the lowest since 2007.

A flattening yield curve has become a key market focus over the past year, since an inverted yield curve has historically been a good indicator of U.S. recessions.

“The point is that the yield curve is not just a signal, but something that could actually weigh on the economy,” David Ader, chief macro strategist at Informa Financial Intelligence, said in a recent Bloomberg column.

Higher short-term rates make adjustable-rate loans more expensive, while lower long-term rates cut banks’ profits, which often causes tighter lending patterns.

“To the extent the stock market is a proxy of economic sentiment, any shift in allocations in favour of, say, bonds will take its toll,” Ader said. “At the levels where stocks are currently trading, selling often begets selling as investors ‘strategically’ rebalance.”

The recent flattening shouldn’t be ignored, but it’s important to note that the yield curve always tends to behave this way after the U.S. Federal Reserve begins hiking interest rates.

J.P. Morgan equity strategist Mislav Matejka also pointed out that the equity market continued to move higher during most of these hiking periods, as it did throughout 2004-2007 and the 1990s cycle.

“The crucial point here is that stocks didn’t tend to peak until after the yield curve got outright inverted,” Matejka said. “Flattening was tolerated, but not the inversion.”

Investors typically have significant lead time before stocks begin to decline, a minimum of three to five months, and 10 to 11 months on average.

“In other words, equities tended to continue moving higher for almost a year after the inversion,” the strategist said, noting there is a good possibility the curve steepens before ultimately inverting.

That could occur if growth picks up, as the recent upturn in indicators such as the ISM Manufacturing Index and European and Asian PMIs suggest, or if trade tensions ease in the second half of the year.

Though Matejka believes the yield curve is a useful cycle indicator, he thinks concerns over its flattening are premature and the current shape of the curve is consistent with double-digit equity performance over the next 12 months.

“We raise the possibility that the sell signal, when it ultimately does materialize, might not work this time around due to the idiosyncratic nature of the current cycle,” the strategist said. “The curve could invert purely because the global cycle was so de-synchronized this time around.”

Since equity returns are strongly tied to the state of the business cycle, with the S&P 500 declining more than 20 per cent on average during recessions, the timing of the next downturn is critical.

The current economic recovery is already nine years old, which is very long compared to past cycles. But, as Binky Chadha, chief strategist at Deutsche Bank pointed out, what matters for equities is how imminent a recession is.

He noted that shorter-term measures of the yield curve have generally been flat, but over the past year they have steepened, which does not suggest a recession is being priced in for the coming two or three years.

Nonetheless, it’s hard to argue that both the yield curve and investors aren’t demonstrating classic late-cycle action, such as the latter flocking to stocks that are appreciating.

“This is reminiscent of the market action in the late 1990s,” Pavilion Global Markets strategists said in a recent report.

During that period, interest rates were rising and the yield curve was flattening — eventually becoming inverted — and high-momentum stocks such as tech were outperforming in a big way.

Once again, most suspect the cycle is in its last few innings, but nobody wants to miss out on the best-performing stocks.

“The outperformance of momentum stocks is as impressive as it is worrying,” Pavilion said. “This is typical of late-cycle market action.”

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