The email from Banyan Hill’s editorial director was unusual.

It’s not often that she sends out an all-points alert at 8 a.m. on a Saturday morning.

But this wasn’t an ordinary Saturday.

The day before, the spread between the yield on 10-year Treasury bills and 3-month Treasury notes had inverted.

For the first time since August 2007, investors would earn less on the 10-year T-bill than on the 3-month T-note:

Yield Curve Inversion 2007 vs. 2019

Inverted yield curves have preceded the last seven U.S. recessions.

But they don’t cause recessions. Rather, they are symptoms of recessionary conditions in the making.

They’re so accurate at predicting bad times to come that they have roughly the same significance for financial professionals as voodoo curse totems have for followers of that religion, as I recently explained on MarketWatch.

Hence the early morning email from the head office.

I’ve been warning readers about the shaky foundations of the U.S. bull market for quite a while now. Alas, my predictions have finally proved accurate.

But why? How did I know this was coming … and how can you avoid its worst effects?

The Fed Giveth…

The imminent decline in the U.S. stock market will be caused by the same things that underlay the 10-year bull market that preceded it.

To understand why, follow the money.

Let’s start with two facts about interest rates:

  1. Short-term interest rates are set by Federal Reserve policy.
  2. Long-term interest rates are set by supply and demand in bond markets.

Yield curve inversion means that the Fed’s short-term interest rates exceed the rates the bond market sets for the future supply of and demand for money.

That means we need to understand perceptions of the future supply of and demand for money.

Economic indicators from Europe, China and the U.S. itself suggest an economic slowdown is in the offing.

That implies fewer companies and individuals will borrow for investment and consumption in the future.

Bond traders therefore conclude that the demand for money will be weaker in the future than it is now.

So much for demand. But what about the supply side of the equation?

Bond markets know there is an enormous amount of “liquidity” — aka money — sloshing around the financial system. And $2.2 trillion of that money is there courtesy of the Fed.

Between 2009 and 2014, the Fed bought $2.5 trillion’ worth of Treasury bills and mortgage-backed collateralized debt obligations (CDOs). It wanted to drive down long-term interest rates to restart the economy. This was called “quantitative easing.”

Federal Reserve Treasury Security Holdings 2009-2019

But buying that much debt from the market meant that money that otherwise would have been tied up in T-bills and junk-level CDOs was available to chase yield in the stock market instead.

And that’s precisely what it did.

Fundamentally, then, the decade-long U.S. bull market has been based on a massive “loan” from the Fed to the banking system.

But Dare Not Take Away

Institutional investors know there is no “real” reason for current high stock valuations.

So, when the Fed started to unwind its $2.5 trillion loan to the markets in 2018 — “quantitative tightening” — the markets threw a tantrum.

Call it “Taper Tantrum 2.”

The first Taper Tantrum was in 2013, when the Fed tried the same thing. But that time, long-term bond yields spiked because investors worried that a halt in Fed bond purchases would crash their price.

In 2018, the Fed tested the waters by selling bonds and hiking interest rates. That’s what caused the big stock corrections in February-March and December.

So, when the Fed announced last week that it was going to stop its quantitative tightening in September — i.e., cease to sell T-bills — the market experienced a spike of relief.

But bond markets had other ideas.

Traders realized that the threat of a Taper Tantrum means the Fed has no way to claw back its $2.2 trillion gift to the financial system.

With economic conditions weakening, bond traders understand that in the future, there will be trillions of dollars’ worth of free money chasing Treasury bonds instead of investing in a weak economy.

In other worlds, the future supply of money is excessive.

And since demand is expected to be weak, as I explained above, long-term bond yields dropped farther and faster than they would under normal circumstances — and the yield curve inverted on Friday.

A Fake Market Means Fake Profits

The Fed has pumped $2.5 trillion’ worth of liquidity into financial markets over the last 10 years.

At the very first attempt to wind down that position, stock markets freaked out, and the Fed backed down.

To me, that suggests global equity valuations are propped up by Fed policy, not by fundamentals.

There’s an irony in this. Bankers and mainstream economists have been ridiculing “modern monetary theory” (MMT) because they claim it amounts to the government giving free money to citizens.

But that’s precisely what the Fed did with quantitative easing — except the beneficiaries were banks and big investors, not citizens. And when the Fed threatens to take this punch bowl away, markets throw a tantrum.

Readers of my Bauman Letter know that I believe politics is as important as economics in planning your investment strategy. The Fed-engineered yield curve inversion is a perfect example.

Riding the false wave of profits engineered by the Fed is about to come to an end.

That why you urgently need to look for real value and growth prospects in your investments this year, like those I recommend to my readers.

Business as usual won’t do.

Kind regards,

Ted Bauman

Editor, The Bauman Letter