Yield Curve Inversion Aversion

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!  

---