Sunday, September 20, 2020

Upside Down or Right-Side Up?

Ask the CFP


“As sure as the spring will follow the winter, prosperity and economic growth will follow recession.

~ Bo Bennett, American Author born 1972.


Question: Why is there so much concern about the yield curve inverting?

Answer: Let’s start by defining what a yield curve represents. A yield curve illustrates the relationship between time, interest rates and risk. Typically, longer term interest rates are higher than short-term rates because of the perceived risk and uncertainty of tying funds up for longer periods of time. A normal yield curve would slope upwards and to the right. Inversion is when something is turned upside down or in opposite order. There are three possibilities for a yield curve; normal, flat and inverted.

Interest rates essentially reflect the cost of money. When short-term rates are higher than long-term rates, it indicates that the cost money may be lower in the future. An inverted yield curve can indicate concern for levels of future economic growth. Some economists and investors feel an inverted yield curve predicts a recession because the yield curve inverted before each of the last seven U.S. recessions.

On March 20th, in an unusual announcement, Federal Reserve Chairman Jerome Powell told us that the Fed does not plan on raising rates during 2019. Translated, this means that the cost of capital will likely remain low. It also means that higher interest-rates are not needed at this time to slow an overheated economy.

Just two days later, on March 22, 2019, for the first time since 2007, the yield on the short-term three-month Treasury bill exceeded that of the 10-year Treasury note. The definition of an inverted yield curve is when short-term rates are higher than long-term rates. On March 29th, the U.S. Treasury yield curve flipped back with the 10-year Treasury note rate higher than short-term rates.

Quantitative easing (QE) kept interest rates artificially low since the financial crisis of 2007-2008. With this technique, the Fed and Central Banks around the world use low rates to make lending easier in hopes of stimulating economic growth.

QE was a new tactic and the long-term consequences are not yet known. The recent and temporary yield curve inversion could be in part due to QE consequences rather than a predictor of a recession. The yield curve is only one economic predictor, and at the time this is being written, remains un-inverted. Other factors to consider are housing starts, unemployment insurance claims, the Institute of Supply Management’s (ISM) inventory measurement of manufacturing, and inflation, in addition to the yield curve. Of these indicators, the yield curve is the only one flashing a light red warning light. Even if the yield curve is correct in signaling a recession, it’s likely going to be awhile before that occurs. The lead time tends to run one to two years before a continuous inversion emerges into a recession, which brings us well into 2021. A sustained yield curve inversion would be just one sign of recession. In fact, the last yield-curve inversion that sent a true signal of recession was in December 2005 and markets continued in an upward manner for two more years.

If interest rates do increase, risk will be priced more realistically. All else being equal, higher risk ventures will have to pay higher interest rates; investing funds for longer time periods would pay higher rates that shorter-term deals.

What the Fed does next matters. If rates go up too much, a recession becomes a self-fulfilling prophecy. Currently around the world Europe remains stagnate, China is slowly beginning to defrost, and the U.S. is experiencing slowed growth. The Fed can influence financial markets. For instance, when the Fed raised rates last December, markets responded with dismay, and see how markets have responded positively to the news that rates will not likely go up for the rest of 2019.

This time may really be different when it comes to an inverted yield curve. There are factors other than interest rates that may be contributing to slower economic growth that are related to demographics. Underfunded pensions for current and future retirees, an aging population and improvements in productivity resulting from technological improvements could all be adding to the slowdown. Until we determine how to fully value intellectual property, growth could remain at these levels. There has even been talk of the Fed cutting rates to stimulate the economy.

Until more evidence supporting a weak economy appears, it’s difficult to sound the recession alarm just yet. Since the Great Recession of 2007-2008, many corporations and households took advantage of this low rate environment to reduce debt. If short-term rates do go higher, so would borrowing costs. Hopefully, consumers and corporations both learned that being overextended is not a comfortable place to be. Government debt is a discussion for an entire column. Balance and moderation on all fronts may allow us to return to a more normal interest rate environment. Ultimately, when not controlled by artificial means, interest rates are a proxy for risk. Too much emphasis on any one recession indicator may not be wise. Stay focused and plan accordingly.

The opinions expressed are those of the writer, but not necessarily those of Raymond James and Associates, and subject to change at any time. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Past performance is no guarantee of future results. Views are as of April 1, 2019 and subject to change based on market conditions and other factors.

“Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.”

This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email darcie.guerin@raymondjames.com. Website: www.raymondjames.com/Darcie.

 

Leave a Reply

Your email address will not be published. Required fields are marked *