2019 What the Heck is an Inverted Yield Curve Danny Popescu 04/05/2019 1,162 10 Comments Good day, March was another strong month for equities with the numbers coming in similar to February: in CAD the TSX Composite rose 1.01% and the S&P500 3.32% (largely due to the Canadian $ falling 2.06%). The FTSE Canadian Universe Bond Index also had a strong month returning 2.35%, as long-term bonds rallied 4.5% with economic growth being questioned by bond traders. Despite robust equity markets and relatively low volatility, the biggest news of the month was talk of the dreaded “Inverted Yield Curve”: What is an inverted yield curve? The Yield Curve compares long term rates vs short term rates, and the chart above illustrates the spread between the US 10 Year treasury rate (currently yielding 2.39%) and the US 3 Month treasury rate (currently yielding 2.43%). Subtracting the short-term rate from the long-term rate represents a negative inversion of .04%. You’ll note, as illustrated in the shaded bars, that economic recessions have closely followed significant curve inversions. Why do inverted yield curves happen: As economies recover after recessions and growth/inflation becomes strong, central banks raise short term rates to slow the surging economy. As short-term rates increase and borrowing becomes more expensive, borrowing and economic growth slows, which generally reflects in the market’s pessimism toward the economy and anticipation of falling interest rates. This drives bond traders to bid longer-term bonds for capital appreciation (and as yields fall, prices of bonds rise). What are the implications: Yields affect how banks lend money. Banks borrow money from clients (term deposits and savings accounts) and generally pay interest on short terms at a rate between the 3-month and prime rate. They lend it out longer term in the form of mortgages. When short term interest rates move higher than longer term rates, margins are squeezed, and banks may effectively end up paying higher interest on savings than they receive on their mortgage and other lending rates. The banks appetite to lend may diminish, resulting in tighter lending restrictions and reduced lending activity. As this takes time to play out, recessions typically lag the inversion. Common observations of inversion: An inverted yield curve has preceded the last 7 US recessions, so it has a good track record as a precursor to recessions. Yield inversion does not mean a recession is a certainty; it does, however, increase the likelihood that a recession may be looming. Equity markets may continue to rise after a significant inversion (in 2006 the curve inverted and the S&P500 continued to rally 20% before topping out). Conclusions: Different market cycles may show similarities, however, no two cycles are exactly the same. Based on past inversions, we can expect equities to continue to slowly grind higher over the next few months; thereafter the likelihood of an inversion should not be taken lightly and warrant caution over the longer-term. Central banks seem aware of past misguided measures, however, the FED is currently still tightening by rolling mortgage-backed and treasury securities off its balance sheet. Should economic numbers deteriorate further we could see quantitative tightening end sooner than expected (currently expected to end in September). The past two recessions have hit equities hard, and there is more debt in the economy now than ever before. However, going back to the previous point, central banks seem ready to increase stimulus to soften the blow. The yield curve should be observed along with other indicators – such as GDP growth, unemployment rates, and company earnings – to get a more complete picture of how the economy is performing. As a political aside, last week Trump and his advisors were urging the FED for a 50bps interest rate cut, all the while preaching the message the US economy is the strongest it’s ever been! Strong economic activity does not call for a rate cut; conventionally it suggests rates should move higher to slow down growth and inflation. The rationale, while arguably unsound, is to delay the inevitable by staving off a recession leading up to the November 2020 election, which would likely sink his re-election chances. Will the FED maintain its “independence” or get bullied by Mr. Trump? Will a battle ensue? Can the FED maintain any credibility? Stay tuned! Portfolio Implications Timing cycles is nearly impossible and equity markets could continue to rally. For this reason, we continue to hold quality businesses but remain defensive and overweight private debt and other alternative strategies, income-yielding securities, etc. Have a good weekend! 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