If the U.S. economy experiences an economic recession in the next six to eighteen months, it will turn out to be one of the most anticipated and forecasted recessions in history. It seems that everyone from economists, reporters, politicians, and talk-show hosts have been talking about the pending recession since the beginning of 2018. We dare to say that some people have been talking about it long before that. As the oft quoted Yogi Berra said, “It’s like déjà vu all over again.” Only this time, we have an inverted yield curve to explain.
What is a Yield Curve and Why is it Inverted?
A yield curve is a graph that plots the interest rates of similar quality bonds over different maturities. The most watched yield curve plots the various yields and maturities of U.S. Treasury debt. In normal times, the 3-month Treasury bill yields less than the 30-year Treasury bond. Generally, the longer the term of a bond, the higher the interest rate an investor will require. Therefore, the normal state of the Treasury yield curve tends to be upward sloping. However, from time-to-time, the yield curve flattens (i.e. short-term rates and long-term rates are similar) or inverts (i.e. short-term rates are higher than long-term rates).
Historically, an inverted Treasury yield curve has signaled future recessions. Because of this, we have been keeping a close eye on the bond market. As we noted in our First Quarter 2019 Review & Outlook, parts of the yield curve have been inverted since earlier this year:
“Before the first quarter closed out the yield curve inverted. This occurred because the yield on the 10-year Treasury note fell below the yield for the three-month Treasury bill. This was the first time the yield curve has inverted since 2007. An inverted yield curve signals falling growth expectations and historically can precede a recession within the next couple of years. But in the near term, the lower interest rates are resulting in lower mortgage rates that should help support the housing industry, and thus bolster the domestic economy.”
Earlier this week on Wednesday, August 14, the 10-year Treasury note briefly yielded less than the 2-year Treasury note for the first time since 2007. The “2/10” inversion is the most watched recession indicator due to its historical predictive accuracy. This traditional recessionary indicator quickly spooked the stock market and sent most of the major indexes down over 3% for the day. But like all indicators and model predictions, nothing works all the time. Once again, Yogi Berra so eloquently stated, “It’s tough to make predictions, especially about the future.”
How long must the “2/10” inversion last before it’s considered a recessionary signal? There are varying opinions and data on this topic, but the short answer is much longer than a day. As mentioned above the yield curve temporarily inverted on Wednesday by 0.01%, but by the following day the 10-year was yielding slightly more than the 2-year again. As of this writing, the spread between the 10-year and the 2-year has expanded to 0.06%, which is a meaningful move in two days. All must be right in the world.
So why did the 10-year yield drop below the 2-year yield this week? There are a lot of varying opinions, but we believe the main reason has to do with the state of the global bond market and the world’s various Central Bank polices, rather than just a traditional recessionary signal. As we highlighted in our last quarterly report:
“According to various analyst reports there is nearly $12-$13 trillion in negative yielding bonds around the globe. Currently, the Federal Reserve’s short-term rate range of 2.25-2.50% is now among the highest in the world. For example, Australia cut its rate from 1.50% to 1.25% in June, Canada’s key rate is 1.75%, Britain’s key rate is at 0.75% and Japan’s key rate is a negative 0.1%. The European Union Central Bank’s target key rate is a negative 0.4% and Mario Draghi, head of the European Central Bank, has said it may go even lower.”
The latest reports now indicate there is over $15 trillion in negative yielding global sovereign debt. Yes, we know that is difficult to comprehend! Most notably, Germany’s yield curve is negative out to their 30-year bond; the yield curve in France is negative out to their 20-year bond; and Japan’s yield curve is negative out to their 15-year bond. If you are an investor in any of these countries, you would be much better off investing your money in the positive yield environment of the U.S. market.
The flows into U.S. Treasuries have not only pushed down our long-term interest rates, but have continued to strengthen the dollar index which measures the US Dollar vs. the other major currencies of the world. In summary, we are not ready to definitively say the temporary inversion on the yield curve is sending any of the traditional warning signs of a pending recession. However, an inverted yield curve is a significant event and shouldn’t be ignored, and we will continue to monitor the bond market for clues.
This week several prominent economists and investors have echoed our thoughts:
– “Historically, the yield curve inversion has been a pretty good signal of recession and I think that’s when markets pay attention to it but I would really urge that on this occasion it may be a less good signal. The reason for that is there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.” – former Federal Reserve Chair Janet Yellen on Fox Business Network.
– “Any inversion that is going to send a bearish signal for the U.S. economy would have to be sustained over a period of time…the numbers here seem pretty good…2 percent growth. Nice job market. Low inflation. Good consumption growth.” – St. Louis Federal Reserve President James Bullard on CNBC.
– “The bond market is distorted. It is distorted by what’s happening outside the U.S. If you live in an interconnected world, you have no choice but to import the effect of negative policy rates in Europe…that is going to distort our yield curve. And it’s going to weaken the traditional signaling mechanism.” – Allianz’s Mohamed El-Erian on CNBC.
Given Recent Events, What Should You Do?
August is historically a volatile month for investors. As always, we recommend investors remain patient, stick to your long-term investing strategy, and most importantly, ignore all the sensationalistic media headlines. Being patient has continued to pay-off this year. As of August 15th the Dow and S&P 500 are up 9.65% and 13.59%, respectively. According to the Wall Street Journal and FactSet, nearly 60% of stocks in the S&P 500 offer a dividend yield of at least 1.7%, which is higher than the current 10-year US Treasury yield. Lower interest rates tend to be good for long-term, patient stock investors. Data provided to us by Blackrock, the world’s largest asset manager, shows the longer you stay invested, the greater your likelihood of positive returns. Based on rolling returns of stocks from 1928-2018, you have a 62.4% chance of a positive monthly return. However, if you extend the time period out to just 5 years, the odds of a positive return increases to 88.8%. As famed mutual manager Peter Lynch reminds us, “the secret to making money in stocks is not to get scared out of them.”
What happens next?
We still believe the current bull market should remain intact for the foreseeable future. However, until we receive some clarity on trade, tariffs and the Fed’s interest rate policy, we will likely continue to experience heightened stock market volatility. As we said in our latest quarterly commentary:
“Our overall view of the market has not changed since the end of the first quarter. We do not anticipate a recession happening in the near future, interest rates remain low, inflation remains moderate, and the labor market remains strong. However, there are some risks for the stock market for the rest of 2019 and for 2020 that could trigger a decline, such as the ongoing trade talks with China, uncertainty of the resolution of Brexit, and a further weakening in the global economy. Overall, we believe the positives outweigh the negatives. Therefore, we remain cautiously optimistic for the stock market in 2019 and the beginning of 2020.”
The positive factors mentioned in our latest quarterly commentary remain largely intact. Additionally, the Federal Reserve continues to signal their willingness to reduce short-term interest rates. According to FactSet, the probability of another rate cut at the September 18th Federal Reserve meeting is 100%. We remain cautiously optimistic about the stock market in the near-term, although we have recently taken some steps to slightly reduce the equity risk in client portfolios. We are confident that if you take a long-term view of your stock portfolio, you will see more ups than downs.
As a final thought, those with mortgages might want to review your term and interest rate.
Sincerely,
Marietta Wealth Management, LLC