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That History Rhymes Quote

2022-07-22, Clement Chiang

History doesn’t repeat itself, but it often rhymes” – Mark Twain.

Of all the investment maxims out there, I think I have referenced this the most. It may just be out of convenience that I keep returning to this one as I often try to simplify all the economic and market complexities into a quote that’s concise and that resonates. I admit this is a personal favourite.

Market volatility year to date (YTD) has been quite the wild ride, especially in the bond market. In fact, the last time we experienced a larger sell-off than what we have seen was 28 years ago in 1994, when the Canadian government 10-year bond yield (CAN10Y) rose 309 basis points (bps) peak-to-trough in that year alone. The U.S. Treasury 10-year yield (UST10Y) rose 220 bps peak-to-trough in 1994. In comparison, the yield sell-off that we’ve seen YTD (peak-to-trough) of 214 bps for the CAN10Y and 192bps for the UST10Y shows how rare the magnitude of this rate rise has been. We believe this wide swing in bond yields illustrates the extreme change in central bank actions from maniacally driving interest rates to the zero lower bound in 2020, to aggressively tightening monetary policy with super-sized rate hikes two years later. The pivot from max dovishness to max hawkishness in such a short period of time is one of the key contributors to recent market volatility.

Twain’s quote advocates that while each market cycle is unique, each also exhibits many similarities. We believe one such connection is the interest rate backdrop. Policy rates are controlled by central banks, but bond yields are largely influenced by market participants. As the market is forward looking, bond yield valuations have embedded market expectations for the level and direction of policy rates. It is typical for the government yield curve to be upward sloping (long maturity bond yields greater than short maturity bond yields) as investors seek additional compensation for owning longer duration assets. But at times, when the market believes the rate hiking cycle has gone too restrictive and that future policy rate cuts are on the horizon, we tend to see long maturity yields shift below that of shorter maturity yields. When this yield differential pushes below zero, the yield curve is downward sloping and is considered inverted. Yield curve inversion has occurred six times in the past 44 years and has often coincided with an economic recession in the months that follow. The root cause of each downturn is unique, like the global pandemic in 2020 and the housing market unwind in 2008-09. But coincidentally a curve inversion has been a common denominator in many of the past recessions. The chart below shows the term spread between the U.S. Treasury 10-year yield and a U.S. Treasury 2-year yield (UST2s10s) since 1978. Over this period, the UST2s10s has inverted on average roughly 14 months prior to an economic downturn. As shown, this indicator holds quite the strong track record and is why it is so well followed by market participants. While the market is fickle and the future remains as unpredictable as ever, arguably more so today, we cannot help but highlight that the UST2s10s has inverted in recent weeks, in both the U.S. and Canada.

Source: Bloomberg, NBER, QV Investors

While this track record speaks for itself, we certainly recognize that there are many forces at play and some that we don’t yet understand. The unknown unknowns. However, with the information at hand, we do believe the business cycle is swiftly moving towards the late cycle stage, if not already there. Especially as central banks remain focused on aggressively hiking rates to rein inflationary pressures back closer to target. Central bank rhetoric firmly supports that the current trend in monetary policy appears willing to tolerate short term pain (economic deceleration) for long term gain (controlled inflation). While we acknowledge that not all cycles are identical and that this one convenient leading indicator may be overly simplistic, it is difficult for us to fully disregard this as market noise. Perhaps another perspective could be that economic contractions typically emerge when monetary policy is restrictive rather than accommodative. With interest rates already materially higher than a year ago and signalling for more to come, we believe it would be foolhardy to assume the soft-landing scenario that central bankers have laid out. Planning for multiple scenarios and maintaining a flexible approach can help identify excellent opportunities to allocate capital, especially during periods of volatility.

Our investment teams remain disciplined to our bottom-up fundamental process that builds and preserves the quality compounding that we seek. At the same time, we are preparing ourselves for what could be a juicier opportunity set than what is currently available. Our bond strategies have purchased long maturity government bonds at these higher yields to help improve on the stability it provides our balanced portfolios. Also, we have incrementally been shifting our asset mix from equities to bonds to earn the higher risk-adjusted income as well as the liquidity to act during unexpected drawdowns. We believe investors that maintain a value discipline and capital preservation mindset throughout a market cycle can not only navigate the ebbs and flows as they come, but also benefit handsomely when attractive opportunities inevitably find their way.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Clement Chiang | VP & Portfolio Manager, Fixed Income

Clement oversees QV’s investment process and makes portfolio decisions for the fixed income strategies.