Inflation Or Recession? Be Cautious And Remain Liquid

Last week the equity markets switched to full-on panic mode as the major indexes fell precipitously. Most analysts pointed to two major causes of this market move: uncertainty around future tariffs/trade agreements and the partial inversion of the yield curve.

But while it is clear to many why a disruption in global trade can affect the economy and markets, why would the shifting of various interest rates cause investors to sell stocks and lead to plummeting equity prices?

When analysts refer to the yield curve, they are talking about a graph of the interest rates of U.S. government bonds of various maturities. On the x (or horizontal) axis, you have various terms, from one month to 30 years. On the y (or vertical) axis, you have the interest rate for each of these maturities.

Typically, when you connect the points of this graph, you have an upwardly sloping line where the lowest rate is the one-month maturity and the highest rate is the 30-year term. This is because investors demand a premium for tying up their money for a longer term, so longer-dated debt is priced at a higher rate.

Recently, however, the yield curve has started to flatten, meaning that short-dated maturity government bonds had virtually the same interest rate as long dated bonds. This was the result of two factors.

First, the Federal Reserve has been steadily raising short-term rates. It has been doing so to keep inflation in check as well as reverse the abnormally low rate policy put in effect during the financial crisis and resulting recession. Second, longer-term rates have been staying the same or in some cases even falling.

This was partially the result of the recent rise in rates with investors wanting to lock in these more attractive yields. When investors buy bonds, the prices of bonds increase while the yields fall. In addition, long-term yields have fallen as investors worry about economic conditions and sky-high equity prices and have purchased bonds as a safe haven or hedge.

A true yield curve inversion means that the two-year Treasury Bond yield is above the 10-year Treasury Bond rate. This has not happened yet, although the 10-year rate is only about .11 percent above that of the two-year. However, the five-year Treasury Bond rate is currently below that of the three-year Treasury Bond, so the yield curve is partially inverted.

Why do people care about this? Mainly, it is because an inverted yield curve has signaled an upcoming recession with 100 percent accuracy every time in the last 40 years. In other words, every single time in the last 40 years that the 10-year Treasury Bond rate has fallen below the two-year Treasury Bond rate, a recession has soon followed.

But despite an inverting yield curve and volatile stock market, most analysts expect the Federal Reserve to raise short-term rates during its meeting this month and continue to raise rates in 2019.

According to almost all economic data, the economy in the U.S. remains extremely strong which justifies this rate policy. So, on one hand we have the bond market, which is telling us via declining long-term interest rates that the economy will be weakening in the future and investors should flee to the safe haven and current attractive rates of long-term bonds.

On the other hand, we have the Federal Reserve, which by increasing interest rates is telling us that the economy is strong and that investors should worry more about an overheating economy and inflation than a recession. It is these two powerful forces which will continue to add tremendous volatility to all markets until one is proven correct.

Until that time, I would recommend being cautious and liquid. ¦