Dear Clients and Friends, I’ve been meaning to write an article about what we call “the Yield Curve” because of all the statistics and metrics we at MORWM utilize in our forecasts, this is among those we take most seriously. In the midst of confusion in late 2007, the yield curve was the straw that broke the camel’s back, so to speak, and the final concern for which liquidated a meaningful part of our equity portfolio in October and November of 2007. To my pleasant surprise, our good friend Brad McMillan wrote a very well-crafted article about this very topic last week which, today, we share with our readers as part of our weekend reading series. As is often the case, this term “Yield Curve” may sound complicated, but as you read Brad’s article, you will quickly realize that it’s fairly straight forward. Simply put, when investors do things that show they have less confidence in the short run than the long run, that often indicates that investors worry about something which may lay in our path sooner than later. For some time now, we have been steadfast in our optimism regarding most of 2018, but have been preparing clients for possible recession in the shadows that lay beyond. Please take the time to read Brad’s brief article below. It is an excellent representation of why the yield curve is so important to us, and why this metric is a meaningful part of our so called economic-barometer.
A Look at the Yield Curve - The Best Indicator of Economic Risk
One of the key indicators I look at when evaluating economic and market risks is the yield curve, which is a fancy name for how interest rates for different time periods vary. You would expect the rate an investor needs for a 10-year loan, for example, to be different from what she needs for a 3-month—or 30-year—loan. And, by and large, that is the case. Exactly how different the rates are, however, can change quite a bit, and those changes can tell us a lot about the economy. Normal and inverted yield curves Longer loans are riskier than shorter ones, and investors should want to be paid for that risk with a higher rate. That’s common sense; a lot more can go wrong in 10 years than in 2. That behavior—higher rates for longer terms—is almost always what we see, for that reason. But sometimes, shorter rates are higher than longer ones, and that reversal of the normal order is usually a sign of pending trouble. It is called the inversion of the yield curve, and it happens like this: When the Fed gets concerned about inflation, it raises rates at the short end of the curve; this pushes all short rates higher. At the same time, investors become more fearful and their expectations of growth slow, so they want to buy longer-term bonds. This pushes up the prices of those bonds while their rates decline. This combination of policy action at the short end and fear and risk aversion at the long end makes short rates higher than long ones. It’s also a bad sign for the economy, with the Fed purposely slowing things down and investors getting more fearful. This is why the yield curve is a useful indicator of economic risk. Using the yield curve as a risk indicator Using it involves some thought, however. It is easy to say short and long in the above discussion, but what do they really mean in an analytical context? Does “short” mean the fed funds rate, 3 months, or 2 years? Is “long” 10 years or 30? In my economic risk factor updates, I use the 3-month rate and the 10-year rate, but would we get different results using other time periods? Let’s take a look.
This chart illustrates the U.S. Treasury 10-year rate minus the 3-month rate. Rather than charting both rates, the easiest way to look for pending economic trouble is simply to subtract the short rate from the long one. If the result is below zero, then the yield curve is inverted, and trouble may be on the way. Here, you can see that the inversion happened one to two years prior to each of the past three recessions (the shaded areas). So, it’s a good indicator, though it’s not exactly timely.
When we look at the 10-year rate minus the 2-year rate in this chart, we see the same thing—the inversion of the yield curve happened about two to three years in advance of each of the past three recessions. This is also a good signal, but it’s somewhat less timely than the previous chart. The same applies with other pairings. That is why I use the pairing I do (10-year minus 3-month), as it gives the most timely signal. What have we learned? What can we take away from this study? First, the current yield curve does not indicate an impending recession, which is a major positive. Second, the robustness of the relationship, which covers many different time periods and many different sets of rate pairs, suggests that the yield curve is indeed a valid economic indicator and not a result of data mining. Third, there is no need to look for a different economic risk indicator—the yield curve works just fine. All good things to know as we move forward.
To reiterate what Brad and I both agree on is that we are not anticipating an impending recession. However, this is one of many statistics which continue rolling in suggesting that a recession is highly possible within the next few years. Since about this time last year, we have been writing regularly about a possible longer-term inflection in the market occurring sometime between late 2018 and late 2019. Given our confidence in current economic strength, for many clients, we bought into the current stock market dip and we anticipate that to be a profitable trade as the market climbs back to at least one more new high prior to a recession. In fact, the market could continue in its growth path for considerably longer. However, insomuch as we are at MORWM are safety oriented, given the yield curve as seen in the charts shared above, as well as many other metrics we study, this dip will likely be the last one we try to profit from prior to the next recession, whenever that may be. We hope you enjoyed a short piece of education curtesy of our good friend Brad, and we hope you have a lovely weekend.
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC 1801 Market Street, Suite 2435 Philadelphia, PA 19103 P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 | 601 21st Street, Suite 300 Vero Beach, FL 32960 P: 772-453-2810
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