Is the Bond Market Signaling a Recession?

July 19, 2018

Our View (the Short Story)

Although the yield curve is near zero and could invert, we are not concerned about a recession in the near term. Even if the yield curve inverted, history shows that a recession usually does not occur for 6-24 months. We continue to have a positive view of the stock market.

 

 

What's the Issue?

In recent weeks, the media has been buzzing with stories about the "flattening" of the yield curve. Why? Because an inverted yield curve historically has led to recessions, and recessions generally lead to major declines in the stock market. 

 

What is an Inverted Yield Curve?

Yield curves are visual representations of interest rates at various points in time. Ordinarily, long-term interest rates exceed short-term rates. This is because lenders and bond investors typically demand a higher interest rate to tie up their money for a long period of time due to the uncertainty of future economic conditions, including inflation. When the yield curve inverts, short-term rates exceed long-term rates. In these rare cases, it is usually caused by the Federal Reserve pushing short-term interest rates higher to combat inflation or slow down an overheating economy. 

 

Why is an Inverted Yield Curve Feared as a Recession Indicator?

A recent study by the San Francisco Federal Reserve Bank demonstrated that an inversion of the yield curve -- in their study the 1-year Treasury yield exceeding the 10-year Treasury yield -- signaled all nine recessions since 1955, with only one false signal. When short-term rates exceed long-term rates, banks profit much less from making loans, thus reducing loan activity and effectively placing a brake on economic growth.

 

Since recessions often lead to large declines in the stock market, investors are currently very concerned about the possibility of an inverted yield curve. 

 

 

Our View

Yes, we are concerned about the yield curve closing in on zero and then inverting, but it is just one of many economic indicators we watch to determine a vulnerable economic environment. It's important to note that when the yield curve inverts, a recession usually doesn't occur for 6-24 months. 

 

Equally important, some of the strongest stock markets in history have occurred during an inverted yield curve. For example, the yield curve inverted in January 2006. The stock market climbed more than 20% after the inversion before it finally topped more than 20 months later in October 2007. 

 

If the Federal Reserve continues with its stated policy of consistent rate increases and inflation remains modest, the yield curve is likely to invert in the year ahead. This will definitely be a concern to us, but given the historic lag time between inverted yield curves and recessions, we may not reduce the risk of our portfolios for some time.  

 

It is also possible that this yield curve inversion could be different. The Federal Reserve is currently raising short-term rates to bring them back to normal levels, not to combat inflation or slow an overheated economy. Moreover, longer-term rates have been pushed down to artificially low levels by the Federal Reserve's quantitative easing policy in which it purchased large amounts of long-term bonds over several years. This impact is now being slowly unwound, which should eventually allow longer-term rates to normalize at higher levels.

 

For now, we remain positive on the stock market. In fact, we believe investor concerns about the yield curve create a more bullish environment for stocks because it reduces optimism. Market peaks generally occur with exceptionally high levels of optimism -- we're not even close to that right now. Hang in there: the yield curve is not a major concern yet and stock market conditions remain constructive.

 

Have any questions? Please give me a call at (847) 602-6485. I'm happy to discuss with you.

 

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Deerfield, Il 60015

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