For those of you who have been watching interest rates (and really, who hasn’t), something interesting is happening: the yield curve is starting to invert. In what could be the natural progression of a process that started at least five years ago, the long term interest rates are dropping below the short term rates. And this could be an ominous sign.

A yield curve is the graphing of interest rates of different maturities of a certain type of security. In this case, US Treasuries. The curve basically shows the relationship between short term and long term rates. A normal yield curve will slope upwards from left to right. That is, longer term rates should be higher than shorter term rates. This is largely due to the expectation of growth in the economy and therefore inflation. This inflation means that investors will demand higher rates in order to tie their money up for longer. When the yield curve inverts, it points to an environment where future growth is expected to be lower than current growth.

There are several reasons why the yield curve might invert. Signs of disinflation, slower economic growth, lack of consumer confidence, etc. But a more immediate possibility is the Fed. Yes, we like to blame the Fed for lots of things, but historically there is some evidence for this. And this time around is no different. When the Fed started raising interest rates in December of 2015, the ten year Treasury was yielding about 2%. The overnight fed funds rate* was essentially at 0%, which held the three month Treasury around 0.12%. After, nine rate hikes, the Fed Funds target rate stands at 2.25% – 2.50%, while the ten year Treasury has barely budged. The Fed has been trying to “normalize” short term rates with the hope that long term rates would rise. However, the latter did not happen. What happened last Friday (3/22) was that the ten year US Treasury note yield closed at 2.437%, ever so slightly below the three month US Treasury bill yield of 2.459%. A spread of -0.022.

So, why is an inversion important? Well, the first thing to look at is what the bond market is telling us. Interest rates essentially reflect the collective wisdom of the bond market. And bonds are clearly saying that growth in the US and around the world is slowing. While the Fed can control the short rates, they cannot directly control the long ones. And, it’s not just here in the US. The German 10 year Bund was yielding 0.016%^ on 3/22, while the Japanese 10 year JGB closed at -0.07%** (yes, that is a negative sign).

Perhaps even more intriguing is that, historically, yield curve inversions have been uncanny predictors of recessions. Way better than the stock market, which as the late economist Paul A. Samuelson commented decades ago, has predicted nine of the last five recessions. The last seven recessions (since 1970) have been preceeded by an inversion of the yield curve***. But, it’s important to keep a couple things in mind. First of all, timing: recessions have followed yield curve inversions by 12 to 24 months. So, it’s not like the sky is falling right now. We are still seeing decent growth in the US. And second, as painful as they are, recessions are a normal part of the business cycle. A business cycle consists of a period of expansion, which leads to a peak, then a period of contraction, which leads to a trough. The period of contraction is generally what we call a recession. According to the National Bureau of Economic Research (NBER), there have been 32 recessions since 1854^^. Every economic expansion has been followed by a contraction and vice versa.

It’s important to note that there are several points at which the yield curve can invert. The ten year v. the two year (the one I watch) has not inverted yet, but is very close with a spread of about 0.12. The fives v. twos has already inverted once back on 12/3/2018. But, these two maturities are very close in distance (and less important for the economy) so this was hardly noticed. And, the 30 year v. the ten year spread has actually increased since last September. As more points on the yield curve invert, and possibly stay inverted, it will be interesting to see how the stock market and the economy react. A yield curve inversion does not necessarily mean that a recession is imminent. But, it’s another piece of data to add to the analysis.

 

* “The federal funds rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis” – Investopedia. The fed funds rate is directly controlled by the Fed through the Federal Open Market Committee (FOMC).

^https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/euro_area_yield_curves/html/index.en.html

** https://tradingeconomics.com/japan/government-bond-yield

*** https://www.clevelandfed.org/our-research/indicators-and-data/yield-curve-and-gdp-growth.aspx

^^ https://www.nber.org/cycles/cyclesmain.html

Gavin Chinn, CFS* Financial Advisor

Check the background of this investment professional on FINRA’s BrokerCheck.

An Investment Advisor registered through CUSO Financial Services, L.P., Gavin has 22 years of experience as an advisor in the Puget Sound area.

“I believe every client is unique and deserving of a personalized financial plan that will help them reach their individual financial goals. Before I make any recommendations, I like to get to know my clients. By asking the right questions, and developing an honest, trusting relationship I can really get a sense of what’s going to work best for them.”

Gavin graduated from the University of Washington with a BA in Business Administration and started his financial career with US Bank in the Investment Department. Prior to joining Verity in 2006, he spent eight years with Piper Jaffray.

So what is Gavin’s vision for his dream retirement?

“My dream retirement would be absolutely worry free: financially, emotionally, and in every aspect of life. My finances would be in order so expenses for travel, luxuries, and gifts for the kids, grandkids, and great-grandkids would be taken care of. My kids would be financially sound, so I would be confident in their prosperity. This would give me the freedom to travel and play and do whatever it is I want to do.”

When Gavin’s not working, he enjoys spending time with friends and family, watching Husky football, and taking weekend trips around the Northwest.

Gavin is registered to transact securities business in the states of WA, OR, CA, AZ, FL, HI, ID, IL, MN, NM, NY and VA.

*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. Verity Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.

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