Those of us who follow the business news or even the nightly news have heard about the “inverted yield curve” and what it may mean for the economy. An inverted yield curve means that the 2-year Treasury yields more than the 10-year. Normally, yields increase with time, theoretically compensating investors for taking more risk for holding longer dated securities. Although the 2-year Treasury currently yields only a small fraction of a percentage more than the 10-year Treasury, it has sparked a conversation about the risk of an oncoming recession. Typically, a yield curve inversion is viewed as a signal of a future recession, albeit often with a relatively long lead time. In the past five economic expansions, the U.S. economy has peaked an average of 21 months after the difference between the 2-year and 10-year year yields initially turned negative.
Although the yield curve’s shape is discouraging, there are few signs of danger ahead. Data show the U.S. economy is on solid footing, and corporate debt spreads have remained contained in this latest bout of volatility. Financial conditions rare still historically loose, yet there are few signs of excess in the financial system. U.S. stocks have been resilient against yield curve inversions in the past. Historically, the S&P Index has rallied an average of 22% from the first inversion to the eventual economic peak. The labor market is at full employment, and healthy wage growth is fueling strong consumer activity. However, a favorable labor market often occurs late in the business cycle. Corporate profits are at record levels, but profit growth is slowing. We will probably see more evidence of slowing profit growth as 3rd quarter earnings are reported in October.
It is a curious time for global fixed income. Treasury yields are being weighed down by intense global buying pressure amid ultra-low sovereign debt yields elsewhere. There are $15 trillion in investment grade bonds trading at negative yields. But recessions can be self-fulfilling prophecies of market sentiment. Businesses stop investing, and consumer behavior becomes more conservative. We take that risk seriously. In the meantime, consumer buying seems robust, and falling interest rates should spur housing activity.
The yield curve inversion sends an important market signal to the Federal Reserve Bank (Fed). Fed policymakers are reducing short-term interest rates to normalize the relationship between short and long dated securities. The market expects the Fed to reduce the Fed Funds rate an additional one or two times before the end of the year. Slower economic growth and weaker corporate earnings may induce further market volatility. However, the Fed is already on track to lower rates in order to extend the current economic expansion, which is now in its 11th year. The effect of changes in interest rates can be delayed by six months or more. So, there is always a chance that the economy could slip into a shallow recession before the lower interest rates take effect. We will continue to monitor the yield curve and incoming economic data.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial.
- All investing involves risk including loss of principal.
- All indices are unmanaged and cannot be invested into directly.