Growth has slowed around the world and long-term interest rates have responded. In fact, the 30-year US Treasury rate recently broke below 2%, which resulted in a new historical low. Furthermore, German 10-year bunds are now yielding -0.65% as their economy teeters on recession and there are 13 countries in Europe with negative yielding 10-year debt.
The US bond market believes the Federal Reserve has been slow to react, as a result 10-year Treasury yields have fallen to the same level as 2-year Treasury yields. Last week, 10-year interest rates briefly fell below 2-year rates causing what the market refers to as an ‘inverted yield curve.’
What is a yield curve? The yield curve graphically illustrates the relationship between shorter and longer-term interest rates. Most of the time, this curve is upward sloping, with short-term interest rates typically lower than long-term interest rates. This is because investors typically demand a premium for having their rates fixed for longer periods of time.
Why is it important? When bond investors feel like the Federal reserve has raised interest rates too high, or that a recession is imminent, long-term rates can fall below short-term ones, “inverting” the shape of the curve.
When the 3-month/10-year curve inverted back in March, many investors took comfort that the 2/10 curve was still positive. Since that is no longer the case, we thought it’d be helpful to reevaluate our March stance regarding the flattening yield curve, especially in light of increased trade tensions and our belief that the Fed is on the case and is expected to cut rates further in 2019.
WE BELIEVE THE BOND MARKET REFLECTS A SLOWING GLOBAL ECONOMY, NOT A US RECESSION: Although it’s always dangerous to assume “it’s different this time,” we don’t believe investors should consider this new inversion as a signal for an imminent recession. As we wrote back in March, there are a few reasons for this conclusion:
- Global central banks have been exceptionally supportive: For the last decade, central banks have suppressed interest rates through various quantitative easing (QE) programs. This has occurred not only in the US, but also in Europe and Japan, where the economies have faced greater deflationary pressures and slower growth prospects. QE programs have dramatically increased the quantity of short-term securities available, while significantly decreasing the availability of longer-maturity bonds. The net result, in our view, is that the yield curve has been distorted by QE and that the efficacy of inversion as a recession signal has been diluted.
- The inversion might be short-lived: Just because the yield curve went from marginally positive to marginally negative, does not mean investors have to change their outlook on all other economic data and information surrounding global markets. Furthermore, the curve can quickly un-invert by countermeasures from the Federal Reserve. Specifically, the Fed can reduce the Fed Funds Rate which would influence the short end of the yield curve. Such a move would likely steepen the curve, reassuring investors that the Fed would support markets if they thought the expansion was at serious risk. Expectations for Fed accommodation continue to increase, such that the market is now pricing in the probability of 2-3 more rate cuts by the end of the year. Thus, we believe the yield curve can remain flatter than usual for an extended period.
- Yield curve has gone mainstream: Given the historical success of the yield curve as a recession signal, it has become more popular and is very closely monitored. Consistent with the old adage, ‘a watched pot never boils,’ we believe it is unlikely that this recession signal will remain the sure-fire indicator that it was in the past. Former Fed Chair Janet Yellen noted this new dynamic when she said that the increased attention on the yield curve has made it “less good” as a recession indicator. Even if we were to believe that the inverted yield curve signal was still valid, historically it has not provided an indication on the timing of the next recession. For example, the curve inverted almost two years prior to the last recession.
- Interest rates are historically low: Absolute interest rates are extremely low. This is important because low interest rates allow companies and consumer to keep the cost of debt relatively low and lowers the probability of a debt cycle abruptly ending. As interest rates go lower, indebted companies and individuals can refinance and reduce their monthly servicing costs. This is apparent today as US refinance applications are running at 3-year highs as homeowners rush to refinance their homes in the wake of 30-year mortgage rates falling to their levels lowest since November 2016 (3.6%). For this reason, we do not foresee a credit induced crisis, like that which occurred in 2008.
Disclosures: Past performance is no guarantee of future results. Shown for illustrative purposes. Not indicative of RiverFront portfolio performance. Index definitions are available in the disclosures.
RISK MANAGEMENT: It is always dangerous to assume that “it’s different this time,” and we don’t take lightly the risk that investors will panic as a result of this recession signal. We think the greatest risk of the yield curve inversion is related to investor psychology, which is already fragile due to China trade tensions, the uncertainty around Brexit, and the global economic slowdown. If so, we need to recognize that the yield curve signal might become a self-fulfilling prophecy and influence consumer and business spending behavior enough to usher in the next recession. Therefore, we will continue to listen to the message of the bond market and monitor the way in which it impacts economic growth.
Bottom Line: While we continue to expect heightened volatility for the rest of this summer, we do not believe the US will enter recession ahead of the 2020 presidential elections. As a result, we are not ready to shift our strategy of preferring equities over bonds.
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The comments above refer generally to financial markets and not RiverFront portfolios or any related performance. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve positive returns, avoid losses, or experience returns similar to those shown or experienced in the past.
Information or data shown or used in this material is for illustrative purposes only and was received from sources believed to be reliable, but accuracy is not guaranteed.
In a rising interest rate environment, the value of fixed-income securities generally declines.
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