Bob's Blasts

September, 2019

 

Markets

Equity markets experienced a pickup in volatility for the month of August as half of all trading days encountered up or down moves of at least 1%. The end result was negative returns for the month on the back of continued trade disputes with China, and the yield curve inverted for the first time since before the financial crisis.  What is an inverted yield curve and why did markets react poorly to this happening? 

In normal economic environments, investors demand a higher interest rate for loaning money for longer time period.   Take a mortgage, for example, the bank will usually charge you a higher interest rate for a 30-year mortgage versus a 10-year mortgage.   The higher interest rate is required due to higher risk being assumed for taking on longer term debt.  This is typically the case for US debt as well.  The interest rate on a 2-year US treasury is traditionally less than the rate on a 10-year US government bond.  

During the month of August, the opposite happened and the yield curve inverted.   The interest rate on a 10-year US bond actually dipped below the 2-year rate, and the rate on a 30-year US bond dipped below the 3-month rate.  Why would someone be willing to lock their money for a longer period of time and accept a lower interest rate?

 

  • Safety and security of US debt - Since the 1950’s, an inverted yield curve has proceeded every recession.  Recessionary concerns due to slowing growth and continued trade uncertainty has led some investors to seek the security of longer-term US debt.  These investors are willing to accept lower returns for the safety they believe US debt provides.  
  • Federal Reserve - Many expect the Federal Reserve to continue lowering short-term rates, which could eventually push them back below long-term rates.  Some investors prefer to lock in lower longer-term rates now, as they expect short-term rates to be much lower in the future.   
  • Speculation - Trading speculation due to slowing growth and the potential for further rate cuts from the Federal Reserve has led to some speculative trading in longer term debt as bond prices can increase when rates drop.
  • Foreign investment due to lower global interest rates - Outside the US, especially in Europe, a large portion of sovereign debt is negative yielding.  While locking in money for 10 years in US government debt at around 1.5% doesn’t sound appealing to many US investors, many European investors have been purchasing US debt as their home countries are actually charging to purchase their government debt.    

While this scenario may seem backward to demand less return for locking in money for a longer time period, it was the environment experienced in August.  An inverted yield curve has historically been one of the most predictive indicators on an upcoming recession.  Generally proceeding the recession by 12-18 months.  Also, we have never been in an environment with so much central bank intervention which may be impacting the yield curve more than economic conditions.  So, what are we thinking or doing as a result?

While we never try to time the market and don’t think its possible to do so, we are looking to rebalance portfolios which have drifted above their target allocation and lock in gains for portfolios with upcoming cash needs.  We have also been positioning portfolios with less interest rate risk as bonds may provide stability to the portfolio. If we see further signals of a slowing economy, we will look to act accordingly. 

This may be a good time to think about your allocation and if you are going to be comfortable with the potential extreme ups and downs that we might experience moving forward.   We are 10 years into this current expansion. While we don’t know when the next recession will happen, we do believe we are closer to the next recession than we are from the last one.  

As always, please reach out if you have any questions or would like to discuss your current portfolio allocation. 

 

 

This material is meant for general illustration and/or informational purposes only.  Views expressed in this newsletter may not reflect the views of Royal Alliance Associates, Inc.  It is our goal to help investors by identifying changing market conditions.  However, investors should be aware that no financial advisor can accurately predict all of the changes that may occur in the market.   This material should not be relied upon as investment advice.  Investors should note that there are risks inherent in all investments, such as fluctuations in investment principal.  Past performance is no guarantee of future results.  There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. This article contains forward looking statements and projections.  Past performance is no guarantee of future results.