Q2 2019 Review - Rates Fascination
The first half of 2019 saw robust gains across the stock and bond markets. While a variety of themes and trends contributed, one topic on the forefront is interest rates.
Two separate interest rate issues have captured the market’s attention: the Federal Reserve’s (Fed) interest rate policy and abnormal conditions in the U.S. treasury market (yield curve). Thus far this year, excitement over the Fed lowering rates has drowned out the yield curve’s warning sign.
In our Q1 newsletter, we discussed the Fed’s U-turn. After broadcasting that it expected multiple rate hikes in 2019, the Fed reversed itself in January and signaled that rates were on hold. Stock markets flipped from sharp December declines to the best January in three decades. Once again, patience rewarded investors who did not panic during declines.
Last quarter marked a second shift in the Fed’s stance. In June, Fed Chairman Jerome Powell indicated that the Bank may lower rates in 2019. The stock market rallied in response. At this point, the market expects multiple rate cuts by the end of the year.
Fed rate cuts typically cause the stock market to rejoice for two main reasons. Stocks become more attractive relative to bonds. And lower rates reduce companies’ borrowing costs.
Bonds also benefit in the short-term when the Fed cuts rates. Already-issued bonds gain value because the market anticipates that new bonds will pay less. If you own a U.S. Treasury bond paying 3% and new U.S. Treasury bonds will pay 2%, then increased demand for your 3% bond raises its price.
The year’s other major interest rate issue is the yield curve inversion. The yield curve plots the relationship between how much U.S. Treasury bonds pay and the length of time until the bonds mature (see chart upper right). As a general rule, the longer until a bond matures, the higher the yield (e.g. the grey line). A yield curve inversion occurs when there is an exception to that rule (e.g. left side of the blue line).
Inversions signal market foreboding over economic prospects. The longer until a bond matures the more it normally pays investors to compensate for the lengthier commitment. But, as of June 30, U.S. Treasuries with maturities less than 12 months paid more than 10-year Treasuries (2.0%). Investors receive a higher rate for locking up money for 6 months than for 10 years.
A recession has not followed every inversion. Yet, an inversion has preceded all seven U.S. recessions over the last fifty years. Bear markets (>20% stock market declines) have accompanied most of those recessions. The common explanation for the inversion-recession relationship is that inversions forecast bond yield declines, which often result from a worsening economy.
Even if the relationship proves prescient again there may not be cause for immediate concern. The average lead time between inversion and recession onset is 16 months. Stock markets have rallied after recent inversions.
There are also reasons to not treat a recession as inevitable. The most widely-followed pair of Treasuries – the two-year and 10-year – has yet to invert. Past inversions occurred when Fed rates were much higher. The yield curve is one indicator among many; most do not point to an impending recession.
Market signals like yield curve inversions are never written in stone. Recognize that forecasters are poor at predicting where rates will go. The Wall Street Journal surveyed 69 economists and analysts in January. The consensus was that the 10-year Treasury would rise to 3% mid-year. None predicted the yield would fall below 2.5% this year, let alone down to 2%!
Inversions are apt occasions for attention, but we remain focused on what we can control. We are evaluating our portfolios to ensure that they are well-diversified and that our bonds limit excess risk. We continue to monitor the Fed and the yield curve and will only make portfolio adjustments when prudent.