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Q&A: Equitas Capital Advisors' Derek Fossier on getting ahead of the yield curve.

Byline: Lance Traweek, Managing Editor

Derek L. Fossier, director of investments at Equitas Capital Advisors LLC, said there's been a lot of talk lately of the yield curve inverting. The New Orleans-based firm recently released a report detailing the latest movement, which could signal changes in the economy.

Fossier said a yield curve is simply a line chart of interest rates for government bonds, with interest rates on the left axis and maturities on the bottom axis.

"A normal yield curve slopes upward, demonstrating the additional yield investors typically demand in exchange for a longer maturity date," Fossier said."When interest rates for bonds with a longer maturity trade at a lower yield than bonds of a shorter maturity, the relationship is said to be inverted."

He said an inverted yield curve signals that market participants expect rates to be lower in the future than they are today.

"This can be an ominous sign for the future," said Fossier, who iterated that a recession could be on the horizon.

Why is the yield curve inverting such a big deal?

Since the late 1970s, there have been five episodes of a yield curve inversion with each followed by a recession.According to the Federal Reserve Bank of New York, there is a 27 percent probability of a U.S. recession in the next 12 months, based on Treasury spreads.However, history has shown that a yield curve inversion lasting for a quarter precedes an economic recession 100 percent of the time. Luckily, the ominous inverted yield curve was short lived and lasted only six days until March 28.In the past, an inversion had to be sustained for nearly a full quarter to be considered a reliable signal.

Has anything happened recently which might affect the validity of the yield curve inversion?

The market environment today is not the same environment we had decades ago.Since the Great Financial Crisis in 2008-2009, the Federal Reserve made unprecedented changes to their toolkit, including paying interest on excess reserves parked with the Central Bank.On top of that, the Federal Reserve recently embarked on a relatively more common tightening mission, increasing rates seven times in the past two years.These actions have the effect of pushing up rates on the shorter side of the curve.Additionally, the Fed's balance sheet remains swollen from the multiple Quantitative Easing programs that began after the Great Financial Crisis.In this program, the Federal Reserve purchased long-dated treasuries in exchange for cash, which had the effect of pushing down rates at the longer end of the curve.An astute investor would conclude that these changes, which push up the shorter end and push down the longer end, make an inversion of the curve more likely.

Are there other signals we can look at to help determine where the economy will be in the future?

Looking at current economic data would be another way to gauge the likelihood of recession.Concurrent economic activity has slumped lately, evidenced by a smaller consumer spending number and lower manufacturing activity. However, leading indicators, which forecast the upcoming economic trajectory, suggest a return to growth, albeit a slightly slower growth.

Ataman Ozyildirim, director of economic research at The Conference Board, said the U.S. LEI (Leading Economic Indicator) Index increased in February for the first time in five months.

"February's improvement was driven by accommodative financial conditions and a rebound in stock prices, which more than offset weaknesses in the labor market components," Ozyildirim said. "Despite the latest results, the U.S. LEI's growth rate has slowed over the past six months, suggesting that while the economy will continue to expand in the near-term, its pace of growth could decelerate by year end."

This is almost the longest bull market in history, aren't we due for a recession soon?

The current economic expansion has lasted more than nine years, almost the longest bull market in history.However, bull markets do not die of old age; they die of excess valuations, aggressive Fed tightening, or other large shocks.The S&P 500 ended March with a forward P/E ratio of 19.21, according to YCharts (a financial data research platform), which is high but still within the range of normal valuations.Additionally, Fed Chair Jerome Powell recently signaled patience, putting interest rate hikes on hold for "some time."With the first two conditions all clear, the current stretch of economic expansion could continue for some time.

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Publication:New Orleans CityBusiness
Date:Apr 30, 2019
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