There was a lot of talk Friday on business news channels about the “yield curve inverting”.  This is not the first time this has happened recently, but it did seem to carry more weight this time around.  The stock market fell around 2% based on this event.  What exactly is a yield curve inversion and what implications does it have for us?  Before getting into that let me back up half a step and explain a couple of concepts. 
 
First, I want to briefly explain how bonds work.  Think of a bond as an interest-only loan.  If you buy a bond you are loaning money to a company (i.e. Tesla, IBM or ExxonMobile) or municipality or government.  In exchange for this loan, the entity agrees to pay you a set interest rate for the term of the loan.  At the end of this loan the entity will pay you the last interest payment and repay the original loan amount.  This repayment date is known as the maturity date.
 
Typically speaking the longer the term of the loan, the higher the interest rate paid.  This makes sense.  If you are agreeing to tie up your money for ten years you would demand a higher return than if you were only loaning it out for two years.  This is an important concept to understand when we start talking about the yield curve.  The yield curve is simply a graph of the interest rate you would expect to receive relative to how long until the bond matures.  The shorter the time to maturity the lower the interest rate you would collect and the longer the time to maturity, the greater the interest rate.
 
More specifically, the yield curve investors are concerned with is that of Treasury securities – bonds of the U.S. Government.  We would start with a 3-month T-bill and move out in maturities through the 2-year note, a 5-year note, a 10-year bond and finally a 30-year bond.  Suppose a 3-month bond paid you 2% in interest while a 1-year bond paid 2.75%, a 2-year bond paid 3.35%, a 5-year bond paid 4% and so forth.  The normal yield curve would be a sort of gradual upslope as in this picture from Investopedia.com.                                          (https://www.investopedia.com/terms/y/yieldcurve.asp). 
 
Again, this is normally what we would expect for investing in a bond.  We would receive a bit more interest for tying up our money for each additional year.  When things are dramatically different from this situation, we need to pay attention.  That is where we currently find ourselves.
 
In early December we had the first hint of things going wrong.  On December 4 the interest rate on a 2-year Treasury note ended the day higher than the interest rate on a 5-year Treasury note.  In other words you were paid more to invest for only two years than if you invested for five years.  This is not a normal situation.  The stock market fell 1% for the day.  In fact, it continued to fall up through Christmas Eve where it bottomed out. 
 
In early-January Fed Chairman Jay Powell gave a presentation to a roomful of economists.  He said the Fed was essentially done with raising interest rates and would be paying much closer attention to the markets (meaning the stock market, of course).  This calmed markets and a rally started.  But should we still be worried?  Was the December inversion a blip on the radar?  Should we be worried and, if so, about what?
 
It turns out that a yield curve inversion does offer up something we should be concerned about.  The yield curve inversion is a great predictor of a recession.  In fact, the last seven recessions were preceded by yield curve inversions.  If we really are facing a recession, why hasn’t the market melted down yet and what caused the Friday panic? 
 
March has given us some rather troubling economic data.  One key economic report people pay attention to is the jobs report – the report of the number of new jobs that were created in the economy for the prior month.  In early-March we received the report for February.  Economists had been expecting 190,000 new jobs but the report came in at only 20,000 new jobs for the month.  This is also well below the average of over 220,000 new jobs added each month for 2018.  In addition, there have been reports from around the globe of slowing economies.  Manufacturing in Germany hit a multi-year low last week.  We learned that retail sales in December were far lower than anyone expected. 
 
The Federal Reserve met this past week to discuss whether to raise interest rates again.  They had a two-day meeting, releasing the results on Wednesday.  As was widely expected interest rates were left unchanged.  In fact, they stated they did not expect to raise interest rates at all this year and perhaps only once next year.  This received the lion’s share of the press. 
 
However, what disturbed me most – and was not very widely discussed in the financial press – was what the Fed’s outlook was for the U.S. economy.  In announcing their rate decision, the Fed accompanied it with commentary on what went into the decision.  The key takeaway for me was their comment about lowering the expectation for growth in the U.S. economy for this year.  The Fed cut their expectation for economic growth from 2.3% back to 2.1% for this year.  Let me be clear.  The fact that our economy may slow from 3.4% growth last year to just over 2% this year is not a recession.  It is a disturbing trend, though.  If the inverted yield curve prediction is correct we are likely to enter a recession early next year.
 
Believe it or not, as troubling as the yield curve inversion was in December, that is not what led the markets to fall on Friday.  When the interest rate on the 3-month Treasury bill rose above the interest rate on a 10-year Treasury bond on Friday investors were ready to see the worst.  This was almost confirmation of what happened back in December.  Investors greeted this news by selling in droves.  The broad stock market fell about 2% for the day.  The small cap index Russell 2000 fell over 3.5% for the day.  Whether this continues into next week or not is anybody’s guess.  Again, I will reiterate that a recession is not right around the corner.  However, this knowledge of what could happen and when gives us the advantage of being able to re-position accounts for a potential recession.  For example, if our economy does turn negative, the Fed is more likely to cut interest rates next year rather than raising them.  This would bode well for bonds giving us one place we might look for safety.
 
Does this potential meltdown frighten me?  Not at all.  I have been expecting this.  In fact, I would welcome a pull back in the broad market.  After bottoming out on Christmas Eve the markets rallied over 21% through last Thursday.  This was, in my opinion, too far too fast.  If markets do fall it would give me the chance to put some of the cash in client accounts to work.  In fact, I did a little bit of that on Friday.  I am ready to continue this trend on Monday, but I also have two or three other ideas in mind as well.  When markets move in extremes like this there are pockets of inefficiency.  Stocks get mispriced and offer up tempting investment opportunities.  I have a list ready of ideas that I would love to pounce on if given the chance. 
 
As always, I welcome your questions or feedback!  

​I started out to write a blog earlier this week about the Federal Reserve and their balance sheet and discovered that I was spending way too much time trying to explain myself rather than just writing.  This is when it dawned on me that many people probably have little to no idea how financial “stuff” works.  Exactly what is a bond and how does it work?  What does the Federal Reserve do, and why do I care?  What is the difference between a mutual fund and an ETF (exchange traded fund)? 
 
With that in mind I decided to embark upon a series of blogs that will attempt to explain many financial concepts.  If you have an idea or concept in mind that you particularly want addressed, please feel free to leave me a comment below or drop me an email with the request.  For now, I thought I would like to start with a concept that even the President seems not to quite comprehend but is quite relevant currently – trade deficits.  This is particularly timely as it was announced this week that our trade deficit is at record levels despite tariffs. 
 
I recently watched an informal news conference Trump did from the Oval Office.  During the question and answer time one reporter asked about a trade deal with China.  Trump’s answer included a line that took me aback.  In attempting to explain the current negotiations with China, Trump stated: “Our country lost $800 billion last year with trade.  Eight hundred billion.” 
 
On the face of it, this sounds quite scary!  We lost HOW MUCH?!  We need to stop this!  Immediately!  But wait a minute…. Lost how?  Did we really “lose” here?  What the President was referring to is our trade deficit.  Let me explain what a trade deficit is and how we are not, in fact, “losing” when we have a trade deficit with another country.
 
Let us start with the basics.  The U.S. manufactures many things – Fords, Budweiser beer, Jack Daniels whiskey, Harley Davidson motorcycles and so on. At the same time, other countries manufacture things we want – BMW’s, Apple iPhones, Nike sneakers, Moet champagne and so on.  We send Budweiser beer to Europe while they send Moet champagne here.  This is international trade.  At the end of the day, the government scorekeepers add up how much we shipped overseas and subtract from that what we spent buying goods shipped to us from other countries.  If we shipped and sold more Budweiser or Harley Davidsons than we spent on Moet or Mercedes, we have a trade surplus.  If we bought more foreign goods than foreign nations bought from us, we have a trade deficit.    
 
So, with that concept in mind, a trade deficit simply means we bought more goods from foreign manufacturers than we shipped and sold overseas.  Does that mean that we “lost”?  After all, if we want champagne more than we want Budweiser, is that a negative thing?  Let me explain this another way.  If I fill up my gas tank and pay cash for the gas, I now have a trade deficit with the gas station.  I have sent more money to their side of the ledger than I have received from them.  But here’s the rub.  I got a benefit for that $25 “trade deficit”.  I received the benefit of a tank of gas.  Am I worse off for having spent the money?  No, of course not!
 
This is exactly how trade deficits work in the real world.  If we send more money overseas than we take in, we have a trade deficit, but we have (presumably) received some benefit from this bargain.  We have more Samsung Galaxy phones and Nikes and BMWs than we did before.  This is not necessarily a bad thing.  Where I think people – including the President – seem to miss the boat is conflating a deficit with “bad for America”.  Just because we buy more goods or services from a country than they buy from us does not equal “bad for America”.  In fact, we must have received some benefit from this relationship like my tankful of gas, or we would not have made those purchases.  We wanted those Nikes or BMWs or Samsung Galaxy phones. 
 
Our biggest trade debt is with – no surprise here – China.  We mainly import consumer electronics, clothing and machinery from China.  The first two should be no surprise.  Think Apple iPhones or Nike shoes.  Even the President’s family isn’t immune from outsourcing to China as first daughter Ivanka, until the middle of last year, ran a now shuttered clothing line that was manufactured in China.  Why don’t U.S. companies keep all manufacturing here at home?  Cost is obviously one answer.  It is much cheaper, even with shipping, to have an iPhone made in China than here at home.  With minimum wages going up throughout states, either by law or by pressure from other companies, these labor-intensive jobs are likely to remain offshore. 
 
Let’s dig a little deeper into how we rack up a trade deficit, even on goods that are made here.  One of the key items traded in the NAFTA zone – Canada, the U.S. and Mexico – is auto parts.  The Ford Escape is assembled in Kentucky making it an American-made car. However, 55% of the parts that go into the car, including the entire engine, come from Mexico or Canada.  The engine that we purchase from Canada counts in the calculation of what is bought and sold between countries.  That is, when we purchase engines without shipping something of equal or greater value back to Canada, we have incurred a trade deficit.  So, the Ford Escape is assembled and resold mainly in the U.S. with Canadian engines and we end up with a trade deficit.  But did we lose on this deal or not?  Presumably, if Ford could source engines as cheaply here in the U.S., they would.  Using Canadian engines is apparently saving Ford on the cost of building the Escape and allowing consumers to more easily afford this vehicle.  That would seem to be a benefit to everyone involved – Canadian and American. 
 
The bigger issue and thornier question concern the outsourcing of manufacturing to foreign countries at the expense of American jobs.  I don’t pretend to have any easy answers here.  From an economic standpoint, I would argue that we should outsource some manufacturing overseas to countries with cheaper labor.  I do have a problem with using child labor at $1 a day, even if that wage is high for that country.  There is no one single answer to the question of whether we should outsource or not.  In the end, if we are getting the products we want at prices we want, outsourcing to other countries can be mutually beneficial.  I would love to hear your thoughts and ideas below.