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Yield Curve Inversion. Now What?

Matt Ristuccia, MBA, CFA

Matt Ristuccia, MBA, CFA

Matt is Co-Chief Investment Officer at Argent Wealth Management, LLC

Headlines were made last week as the U.S. government (Treasury) yield curve inverted. This means rates on the short-end of the curve are yielding more than some rates at the long-end of the curve.

Investors are now pricing in that the Federal Reserve is more likely to cut rates than to raise rates this year. Investors are reaching for the safety of longer-dated “risk free” bonds as they expect enough of an economic slowdown that 2.4% on a 10-treasury is a fair price. This all implies the Federal Reserve was too quick to raise rates last year, and that was one of the major reasons we saw a 15% correction in U.S. markets in the fourth quarter of 2018.

Note the market is pricing in a zero percent chance that the Fed Raises rates this year, and good chance the Fed lowers rates in the second half of the year!

The global economic environment remains weak, and the bond market is reflecting lower global growth expectations.

Despite the inversion and growth fears, the stock market has rebounded:

The stock market has essentially sent the message, at least so far, that despite negatively trending economic indicators, it expects the economy to remain resilient and real GDP growth should remain in the range of 2.3%-to-2.7%. Clearly the bond and stock markets are sending different messages.

What should investors do with this conflicting message?

1.)  A yield curve inversion is a negative signal and should be taken seriously. The 1-year to 10-year inversion has only given one false slowdown signal since 1950.

2.) However, we remain in a secular bull in stocks; these tend to last approximately 20 years based on historical measures. Slowdowns do occur within long-term bull markets, as can be seen in the chart below, but cyclical bears within secular bulls tend to be shorter-term and less severe than other bear markets:

3.)  In addition, severe bear markets have historically been accompanied by one or two of the following:

  • A large valuation bubble (like 2001 tech bubble). Not present today.
  • A large financial imbalance (like the 2008 housing market collapse due to weak underwriting standards and overly complex securitizations). Not present today.
  • An oil price shock, like we saw in 2008. There was a major one in the 1970’s as well. This is unlikely. The rise of U.S. onshore oil and alternative energy means we believe it will be hard for oil to get much over $80 as there is plenty of profitable supply available at these prices.
  • An aggressive Fed. Although the Fed may have reacted too quickly last year, real rates (Fed Rate minus inflation) are still about or just slightly over 0%.  Therefore, the Fed remains accommodative.

Without any of the above present, if a correction does occur, a 20% +/- 5% type of correction is much more likely than a 2001 or 2008 40-55% type of correction!

Since we already experienced a negative 15% correction in Q4 2018 in the stock market, we are still in the camp that a retest scenario is a buying opportunity. The yield curve inversion adds to the evidence that, in the near term, a retest is more likely than a climb above 2018 market highs. However, a key investment tenet is not to be over-confident in any forecast. It is always important to remain flexible and follow the data.

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