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Money Management: Reading the tea leaves of the yield curve.

Byline: Byron S. Sass

On Dec. 19, 2018 the Federal Open Market Committee voted 10-0 to raise the Fed Funds Rate from 2%-2.25% to 2.25%-2.5%.[1] Even though this move was widely expected, the turmoil in the markets leading up to the meeting and immediately after revealed a lack of confidence. The S&P 500 was down -12.19% from Sept. 28, 2019 through Dec. 18, 2019, the day before the meeting. The S&P 500 continued its downward trend by another -6.21% from Dec. 19, 2018 through Dec. 24, 2018 before rebounding strongly to end the year. This particular rate hike had a very visible impact on equity investors, as many felt the impact when looking at their year-end investment statements. Additionally, while the S&P 500 is currently up 19.72% (through March 22, 2019) off of the low on Dec. 24, 2018, the impact of the rate hike is stilling being felt elsewhere in the market.

What began as tremor for the U.S. Treasury yield curve at the start of December 2018 has since made its presence most felt on March 22, 2019. On Dec. 3, 2018, the 2-year Treasury began to start yielding more than the 5-year Treasury, which resulted in a partial inversion of the yield curve something that hadn't happened in around 13 years. The U.S. Treasury yield curve fluctuated in a state of a weak inversion between then and March 22, 2019 when it made a more definitive move into a stronger partial inversion. On that Friday, the 3-month/10-year and 1-year/10-year Treasury spreads inverted which lends further credence that this yield curve inversion is real.

The main indicator that the yield curve has truly inverted for some economic and investment professionals is if the 2-year/10-year Treasury invert, though some groups prefer to use the 3-month/10-year inversion.

As of March 22, 2019 the 10 Year was yielding roughly 12 basis points (0.12%) more than the 2-year Treasury. In my opinion, with both the 3-month and 1-year Treasury inverting against the 10-year Treasury, the yield curve is in a strong partial yield curve inversion. It will more likely be a matter of when and not if the 2-year and 10-year Treasury invert unless the Federal Reserve intervenes by cutting rates and forcing a normal yield curve.

The reason the 3-month/10-year and 2-year/10-year Treasury spreads demand so much attention is that it they are both seen as reliable indicators for upcoming recessions. The last five times the 2-year and 10-year have inverted they have been followed by a recession. Since 1970 when the 3-month and 10-month have inverted they have been followed by a recession.[2] The inversion of the yield curve is seen as an economic indicator of an official shift in the business cycle from a period of growth to contraction.

In my opinion, this shift has occurred due to the Federal Reserve raising the Fed Funds rate at a brisk pace with the intent of keeping the economy in check. However, with the last rate hike in December they may have overstepped. Put another way, instead of a gentle tap on the brakes to keep growth in check, they have instead slammed on the brakes. This was evident with the inversion of the yield curve, which revealed to the market that growth going forward will be decelerating instead of maintaining a steady pace. To illustrate the change on the outlook on the economy, after the rate hike in September 2018 the markets where forecasting that upwards of three rate hikes could occur by January 2020. As of March 22,, 2019, the forecast is 70% that a rate cut will occur by January 2020 (Source: Bloomberg Finance, L.P.).

With pain fresh from the market downturn in the fourth quarter of 2018, it is understandable to be concerned and worried about what future markets may hold with what I have stated about inverted yield curves implying an impending recession. While we still have not had the 2-year/10-year inversion, everything else on the list of an inverted yield curve has been checked off the list. The good news, as a colleague of mine recently wrote, is that on average a recession occurred 17 months after the initial inversion of the 2-year and 10-year Treasury.[3] He also found that the average performance between the inversion and the recession for the last five times it occurred was 15.82% for the S&P 500 and 9.04% for the Barclays U.S. Government/Credit Bond Index. This means that you should remain in the market for the time being and schedule a meeting with your investment advisor to plan what to do with your portfolio if a recession is on the horizon.

Byron S. Sass, CFA is a fixed income analyst/account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534, (585) 586-4680.

[1] "FRB: Federal Open Market Committee, Statements and Minutes".Federal Open Market Committee.

[2] "Announcement Dates".U.S. Business Cycle Expansions and Contractions. NBER Business Cycle Dating Committee.Archivedfrom the original on 12 October 2007. Retrieved1 March2015

[3] What Happens Historically if the Yield Curve Inverts?" New York Daily Record, published in July 2018,, retrieved March 22, 2019

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Publication:Daily Record (Rochester, NY)
Date:Apr 2, 2019
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