recession indicators

Yield Curve Inversion - What is it and what it means

August 15, 2019

If you were anywhere near financial news yesterday, you likely heard the term yield curve inversion more than a few times and observed a sharp equity sell-off.  We thought it was worth explaining what that term actually means – and why it may matter for investors

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What are bonds again?

The global bond market represents trillions of dollars.  Bonds are financial instruments that companies and governments use to borrow money.  Every bond represents a promise to repay, plus a stated rate of interest for use of the funds over time (referred to as a yield or interest rate).

Wait, how is this different than a stock?

Stocks do not include any promise of repayment.  Instead, stocks represent a share of ownership in a business.  As an owner, you receive your pro rata share of the company’s earnings and growth over time

Got it.  Back to bonds - how are bonds priced?

Again, bonds are a promise to repay issued by a company or government.  Bonds tell a story about the underlying issuer as it’s important to know how likely they are to repay you.  A riskier issuer tends to have to pay more (ie: a higher yield) than a less risky issuer.  In addition, an issuer borrowing money for a longer period of time is willing to pay more (as investors want to be compensated for locking up money for longer and an issuer is willing to pay up to have access to those funds for a longer period)

What’s a yield curve?

The US government is one of the world’s largest bond issuers, with promises to repay at a variety of maturities (from 30 days all the way to 30 years).  The yield curve is the progression of US bond interest rates over the various maturities.  Said another way, if you plotted out the interest rates on each of the US debt maturities on a graph from shortest to longest in a “normal” state, the curve would steadily rise left to right.   Why?  Investors typically demand a higher return for locking up their funds for a longer period of time than a shorter one (and the US government is willing to pay more to have access to funds for a longer period of time).

So in steady state, the rate the US government will pay on a 10-year bond is higher than the rate they pay on a 2 year bond

What’s an inversion?

A yield curve inversion is when the graph we described above slopes downward, implying that shorter maturities pay more than longer maturities.

We saw this happen yesterday, when the rate on the US 2 year bond fell below that rate on the 10 year bond.  

How did this happen?

Bonds trade in the open market, just like stocks, and the pricing of them is driven by supply and demand.  If demand is higher than supply, the price goes up (and the yield thereby goes down as there is an inverse relationship between the two).  So, in recent weeks/months, there has been a higher demand for the 10 year bond than the 2 year bond.  This drives the price of the 10 year up (and the yield down). 

Why would investors favor the 10 year over the 2 year?  It seemingly indicates near-term uncertainty in the US’ promise to repay and implies more value in the 10 year promise versus the 2 year promise, as well as a desire to lock in that offered rate over 10 years

Why did stock markets react?

An inversion of the 2 year/10 year yield curve has been a predictor of recessions in the past, with the recession coming approximately 2 years after such an inversion.  Even though the inversion lasted only part of the trading day, it was enough to cause recession worries, trigger quant funds and algorithms, and lead to considerable equity selling

Is a recession a sure thing?

First, remember what a recession is.  It is NOT two quarters in a row of negative real gross domestic product (GDP) as is commonly believed. 

Rather,   a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” 

There are many data points that have been examined in hindsight after recessions that are now believed to be valuable predictors.  The 2 year/10 year yield curve inversion is one of these metrics.  Recessions has always followed a yield curve inversions - but remember there are also cases where the yield curve has inverted and a recession has not followed.   .

Any good news?

There is always good news. First, a decline in rates is excellent news for borrowers. If you have any debt (like a mortgage), you may want to look into refinancing at these lower rates. Second, while there is a lot of uncertainty and volatility, there remains many positives in the US and globally. If you are an investor and not a trader, you have prepared for this and can endure these moves. Stay focused and don’t rush to react.

View from the Chair: Windermere's Market Perspectives (June 2018)

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Summer has finally arrived.  There is a seemingly endless list of things to do and places to be – leaving even less time than usual to focus on your money and the markets.  What key items should you be paying attention to?  We suggest keeping your “eye on the TIGER” - Trade, Interest rates, Growth, Earnings, and Recession.

Trade  - What started as a war of words (and tweets),  a “trade tiff” has escalated in recent weeks.  It is becoming more likely that a trade war will ensue on some level (if it hasn’t already).  This past weekend, the latest development was Trump leaving the G7 summit early and refusing to sign the joint communique.  Trump’s actions were largely in response to Justin Trudeau’s (Prime Minister of Canada) comments that Canada would “not be pushed around."  Trump remarked of the G7 that the US is “being taken advantage of by virtually every one of those countries.” 

Attention was quickly turned today to the summit between Trump and Kim Jong Un, a historic meeting that led to an agreement by North Korea to dismantle the country’s nuclear program.  Many details remain to be clarified however, this is a very encouraging sign for global relations.

It’s clear that the the US’ role on the global stage and trade equality remains top of mind for the administration and more is certain to come. 

Interest Rates – Interest rate levels serve as a key component in the pricing of financial assets, and as a result, they deserve your attention.  Interest rates have risen since the beginning of the year (Rate on 10 year US Treasury sits at 2.96% on 6/11/18, up from 2.4% as of 12/31/17).  The US Federal Reserve meets again this week and it is highly anticipated they will again raise rates (the 7th such hike since December 2015).

Perhaps of even more interest is the flattening of the yield curve (when short-term rates rise at a faster rate than long-term rates).  The spread between 2yr and 10yr US treasuries is a much-monitored measure and that spread is declining (rests at 0.43% as of 6/12/18). 

Also worth consideration are interest rates around the globe. Both Europe and Japan continue easy monetary policies (albeit at a slower rate), which will present an interesting dynamic as the United States continues to move the other direction (ie: tighter monetary policy)

Growth – 2017 was the year of “synchronized global growth.”  That phrase was repeated countless times as markets reached record levels.  Has that changed in 2018?  No.  There are 189 economies in the world, and 185 are growing (what are the four?  North Korea, Venezuela, Brunei, and Equatorial Guinea).  The US is no exception, with 4% GDP growth not out of the question.  Economies are advancing – and for now, are growing despite the risks posed from potential trade changes and rising rates.

Earnings -  We are coming out of a record setting earnings season in Q1 2018.  Year over year earnings growth for the S&P 500 was 26.6%.  Much of that gain was driven by the tax law changes;  however the fact remains that earnings are accelerating at incredible rates.  It is expected that we have seen the peak in earnings growth rates – but not yet a peak in absolute earnings levels.  With growing economies and improved cash flow for consumers (due to the tax cut and declining unemployment), companies across virtually every sector are seeing improvements in their earnings and that trend is expected to continue.

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Recession – As primarily equity investors, this is a major area of focus.   We are continually evaluating whether a recession appears imminent as that would present a material headwind for many companies in which we are invested and the markets in general.  How can we predict a recession?  We can’t – but we can observe economic data that has tended to be a very strong predictor of recessions in the past.  The data we use most frequently is the Index of Leading Economic Indicators.  It’s a collection of ten data points utilized to predict downturns in the economy.  We look both at the overall trend line, but also at each of the component parts and their trends.  We are focused on whether the data is getting better/worse, not so much whether its absolute value is good/bad.  Below is a summary of the latest reading of the data and as you can see, we are still in a “better” period

Enjoy your summer and be sure to keep your eye on the TIGER.

Invest on,

Pam