Talk on the Street has increasingly included an outlook for a recession sometime in the near future. While this is far from being a certainty (and far from being a consensus opinion), we think it is worth exploring the reasoning behind it, and, perhaps dispelling some of the myths about recessions, market declines, and our power to stop either from besmirching our portfolios.
Earlier this month the yield on the 2-year Treasury note exceeded that of the 10-year Treasury note. Not by much, and not for long. On April 1st an investor could obtain a yield of 2.43% on a T-note maturing in 2024, while an investor buying a 10-year note locked in a yield of 2.38%. This condition lasted for two trading days (Friday, April 1—Monday, April 4), resulting in what the financial world calls an “inverted yield curve”. Wall Street tends to fret when the yield curve inverts for a few reasons. First—an inverted yield curve defies logic. Money has a time-value associated with it. This time-value tends to increase as we ponder the value of a dollar further and further out into the future. This is due to inflation which erodes the value of money to a degree that is correlated with the amount of time our money is exposed to it. So naturally, an investor making a 10-year investment would expect a greater per-year return than one only investing for 2 years.
The “yield curve” is simply the line depicting Treasury spot rates available to investors at any given maturity going out in time, from three months to 30 years—even more. Normally, the yield curve is a convex line sloping upward from left to right depicting incrementally higher rates the longer one chooses to forgo liquidity.
A normal yield curve:
Keep in mind that the only rate the Federal Reserve has direct control over is the Fed Funds rate, the nearest “overnight” lending rate. Historically, adjustments up and down made to this rate (interest rate hikes and cuts by the Fed) reverberate along the curve to varying degrees. Indirect Fed influence over the shape of the yield curve is enacted through “signaling” (speeches, testimony, release of meeting minutes), and lately, quantitative maneuvering in the open markets (QE or QT).
The nearby chart illustrates the value of the spread between the 10-year and 2-year Treasury yields over the last six recessions.
Secondly, the hubbub over the inversion (2’s yielding more than 10’s) stems from the fact that there is a correlation between this occurrence and the appearance of economic recessions—usually within the next 20 months, on average. This correlation goes back to the 1960s. Research shows that 2s-10s inversions have occurred prior to seven out of the last eight recessions. It is critical, however, to remember that correlation is not causation. Inverted yield curves do not cause recessions any more than rainy Aprils cause warmer Mays.
In January, CCR Wealth management declared our position that the US markets had entered into the late-stage market cycle, and we have been managing our portfolios accordingly (quality over momentum, large-cap over small, value over growth, etc). One aspect of our current environment that is uniquely not consistent with late market cycles is the current level of interest rates. Traditionally, late-cycle markets have already seen a series of interest rate hikes by the Fed. Today’s Fed Funds rate resides between 0.25% and 0.50%, having been raised 0.25% by the Fed last month. Even our last recession—a surprise by any measurement because it was rapidly self-induced due to a pandemic—saw the Fed Funds rate at 2.40% prior to the March 2020 emergency. We bring this up as a thought exercise to illustrate what we believe to be the increased vulnerability of the current yield curve, and its possible susceptibility to inversion for reasons apart from economic forecasting.
First, as mentioned, we remain in an environment of low absolute yields. While the Fed has “jawboned” interest rate hikes for the last 4 months, their first actual move wasn’t until March. This jawboning is the “signaling” influence we referred to earlier. Investors, not the Fed, have bid-up 2-year yields in anticipation of future rate hikes because of this signaling. Secondly, the Federal Reserve’s balance sheet is exceptionally bloated, and at roughly $9 trillion, is far and away higher than it was even coming out of the financial crisis (2008-2010). This is the result of quantitative easing (QE), which the Fed pioneered over a decade ago to indirectly influence longer-term rates (by purchasing Treasuries and MBS, demand was created for these maturities which kept a lid on rising yields further down the yield curve time horizon).
Amidst high inflation (and what we believe was a fully recovered economy), the Fed continued to purchase bonds right up through last month. The combined effect of signaling rate hikes to the “front end” of the yield curve and suppression of yields through purchases further down the curve caused a “flattening” of this curve for much of this year so far.
We discussed our expectations that the yield curve would eventually steepen in our January Outlook, and we have watched closely with some concern as the opposite has happened.
While talk of ½-point rate hikes has pushed the 2-year yield from less than 1% to at the beginning of the year to about 2.50% currently—longer-term yields have not kept pace, at least in part due to the Fed’s continued QE. The strong jobs report from March fed assumptions of more aggressive Fed rate hikes early this month—finally pushing the 2-year yield ahead of the 10-year yield—if only for two days.
This narration of how the yield curve inverted is meant to illustrate the technical aspects of today’s curve. That the inversion has a technical explanation can be understood in the short-term context of rate hike expectations and known influences of the Fed’s QE program. QE has now been replaced with QT (quantitative tightening). This means the Fed will begin to reduce the balance sheet by letting maturing notes roll off, rather than be reinvested. The Fed minutes from the March FOMC meeting indicate a consensus among Fed governors that beginning this month approximately $95 billion per month will be culled from the balance sheet. In our view, this is too dovish. Considering the shallowness of the curve with inflation at 40-year highs, we expect a ramp-up in QT could be announced in the months ahead. It remains to be seen whether the policymakers at the Fed agree with us on this point.
While it is true that inverted yield curves have preceded seven of the last eight recessions, this is not enough data to make a statistical conclusion about inversions and recessions. We do not, however, dismiss the historical implications of yield-curve inversions. Late market cycles are often followed by recessions, and the Fed’s track record of engineering “soft landings” is only about 50% over the last three decades.
So, what is an investor to do?
First, understand the tenuous links between recessions, bear markets (or corrections), and inverted yield curves. Importantly, recessions do not precede market downturns. It’s usually the other way around. Secondly, since 1929 there have been 26 bear markets, yet only 15 recessions. So not only are recessions not a predictor of bear markets, but bear markets are also not even very good predictors of economic recessions.
Turning our attention to a history of inverted yield curves we present a chart recently sent to us by Goldman Sachs examining returns on the S&P 500 in various periods following an inversion.
At a glance, we think it is easy to see that using yield-curve inversions as some sort of a signal to drastically alter your investment strategy does not have a history of great success. Here we are again reminded of the wisdom of Peter Lynch, famed portfolio manager with Fidelity for 13 years: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves.”
2022 thus far has certainly challenged us from a portfolio management standpoint. As you know, we spent the latter part of 2021 and the first weeks of this year paring our growth exposure, bolstering our value exposure, and reigning in durations within the bond portfolio. From a sector perspective, Energy, Utilities, Consumer Staples, and Healthcare have outperformed, and are all positive as of this writing. The seven remaining GICS sectors that make up the market are negative, with Information Technology and Communications Services (think: social media) performing the worst. In short, these sector performance distinctions are completely in-line with late-market cycles.
At 8.50% we believe inflation to be a bigger challenge to our economic lives than our investment portfolios, though persistent rates higher than this could be problematic, and we remain vigilant. There is some evidence that supply-chain, Covid-related shortages are easing. Of course, this has been overshadowed in recent months by the Russia-Ukraine conflict. We have added an element of commodities to our model portfolios to hedge, at least in part, the effect this unfortunate war is having (and will continue to have) on prices ranging from energy to food and basic materials. The sizing of this position is difficult to “get right” across multiple client profiles, so we encourage you to discuss this, and your outlook for inflation with your financial advisor.
The world keeps turning, and it changes quickly. We live in a different world geopolitically speaking than we did just two months ago. And two months ago, the world was a far cry from our experiences in the depths of the pandemic shutdowns. We will endeavor to remain nimble, yet circumspect as we navigate our path forward. Please do not hesitate to contact your financial advisor if you have any questions prompted by this Outlook.
The views are those of CCR Wealth Management LLC and should not be construed as specific investment advice. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Investors cannot directly invest in indices. Past performance does not guarantee future results. Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards.
Securities and advisory services offered through Cetera Advisors LLC, member FINRA/SIPC, a broker/dealer and a Registered Investment Adviser. Cetera Advisors LLC and CCR Wealth Management, LLC are not affiliated companies. Cetera Advisors LLC does not offer tax or legal advice.
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