Room To Run In Public & Private Non-Residential Spending

Yield Curve Expected To Flatten

The latest difference between the 10 year bond yield and the 2 year bond yield is 58.44 basis points. That’s about 8 basis points of steepening from the bottom on January 4th. The CME website shows the next likely rate hike will be in March as there’s a 1.5% chance of a hike on January 31st which is the next meeting and there’s a 68.1% chance of at least one hike in March. The January meeting will be important to determine if the March meeting has a hike. The other important stat is the December CPI which will be released on Friday.

I talk a lot about the yield curve and the expectations for the Fed funds rate, but I never talk about the expectations for the yield curve. As you can see from the chart below, bond investors are the most positioned for a flattening in the yield curve than ever before. This doesn’t appear to be a trade you want to fade as the expectation for a flatter yield curve accurately predicted the flattening in 2017. The closer the yield curve gets to an inversion, the fewer investors will think the yield curve will flatten as there’s less room for it to go down. We’re not there yet because it looks like the Fed will raise rates throughout this year as the economy heats up. I expect the rate hike cycle to end in 2019. A lot depends on where the economy is, meaning how many rate hikes the Fed can get away with.

The crazy part of this situation is Yellen says this time is different as she’s not worried about the inversion which will likely occur in the next few quarters. The reason she’s saying the yield curve isn’t a big deal is because she thinks monetary policy isn’t restrictive like it was in previous inversions. That’s an odd statement. While I agree with Yellen that policy is still loose right now, we don’t know exactly what policy will be like when the yield curve inverts. By saying the inversion doesn’t matter, she’s disagreeing with the market about what it means to be restrictive. When the Fed disagrees with the market, the market usually wins.

We don’t know exactly how many rate hikes are necessary for an inversion. I’m estimating 4 more would do so. To determine if policy was restrictive, I’d have to look at where inflation and growth were at the point of inversion. That’s such a difficult call to make because we won’t know what financial conditions will look like when the inversion occurs until we’re closer to that point. I expect inflation to increase, but the key is how much it goes up by. If the Fed funds rate is above the CPI, I’d say policy is restrictive. The key point to recognize is the Fed is about to whistle past the graveyard. Saying the inversion doesn’t matter would be like a student saying two failing test scores in a row don’t matter. The student shouldn’t be surprised when he fails the class and the Fed shouldn’t be surprised with a recession 1-2 years after the inversion.

Construction Has More Room To Run

As you can see from the top chart below, the real drop in the private non-residential construction spending last cycle was 40%. This was the worst decline since at least 1967. It’s notable that the previous peak to peak growth was 23% which wasn’t out of the ordinary as the average growth in the previous 5 cycles was 21.8%. This wasn’t like the housing construction bubble. The real growth from the previous cycle peak has been -4% which is by far the lowest peak to peak growth since 1967. This reflects the size of the previous decline. The growth per year from 2011-2017 has also been near average as the 8% growth is slightly higher than the 7.3% average seen in the previous 6 cycles. The 6 year growth cycle so far is also near the average which is 5.6 years. The question is if the cycle will continue growing so the peak to peak growth comes close to average. It’s looks like there’s more room to run.

The bottom chart shows the real public non-residential construction spending. The situation is similar as the trough drop of 19% was the worst since 1972 and the peak to peak growth has been -15%. That’s by far the lowest total growth as growth is usually between 15% and 30%. The big difference between public and private non-residential construction is that the growth rate this cycle for public spending has only been 1% per year. The previous lowest growth rate was 4% in the 1990s. One of the key factors will be if President Trump can get an infrastructure plan passed. I think there’s a bipartisan viewpoint that infrastructure spending is necessary and badly needed at the moment. If that occurs, we will see this growth rate improve before the next recession smacks spending down again. Manufacturing, water, and wastewater infrastructure spending is down over 30% from the last peak. Education and healthcare are down 11% and 14% respectively.

Not A Great Time To Buy Stocks

The unemployment rate is 4.1% right now which is a bad sign for investors. The further it falls, the lower the expected returns for stocks. As you can see from the chart below, the real average annualized total returns for the S&P 500 since 1950 are 2.73% when the unemployment rate is below 4.1%. Treasury bonds also have poor returns when the unemployment is low as the lowest quartile has -0.36% annualized returns. On the other hand, if the unemployment rate starts rising, it signals the economy is about to go into a recession. The best case scenario for unemployment is for it to stay right where it is. We’re in the Goldilocks phase. Typically, that doesn’t last for long as the unemployment rate is almost always on the move. Bullish investors are asking for a cyclical indicator to stay still. That’s not a good position to be in.

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