We got a break from tariff talk recently, but it was replaced by talk of the yield curve, unfortunately. The 2 are probably related, as concerns about tariffs, and Hong Kong, and Russia, have caused some stock owners to sell and reposition to bonds. When bonds are bought, their yields go down, helping to create this very low interest rate environment.
Low interest rates often stimulate stocks prices, which is why the Federal Reserve will sometimes lower short-term rates. Other times, though, low interest rates can indicate a slow economy. I have heard recently that roughly a quarter of government bonds from around the world are trading with negative interest rates. In other words, if you invest in one of these bonds, you won’t get interest…you’ll owe it! So, even though our 10-year Treasury bond only yields about 1.6%, that is still higher than roughly three-quarters of the rest of the world’s government bonds! This is causing more money to flow into our bonds, which pushes interest rates down even more.
Eventually, you get what happened on August 14–a yield curve inversion. An inversion occurs when a long-term bond yields less than a short-term bond, a phenomenon you wouldn’t expect. Bizarrely, right now you can get more interest on a 1-month CD than on a 10-year bond. Than may happen when investors think that growth will slow so much in the future that they are willing to accept lower rates for a longer term.
Yield curve inversions can take many different forms, but the one I look at is the 2-year rate and the 10-year rate. When this pair inverts, it has very good track record of predicting a future recession. Clearly, I’m not alone in watching this, as the Dow Jones Industrial Average sank 800 points when the inversion occurred. What is not at all clear is when that recession might take place. On average, a recession has begun 12-15 months after the inversion, and the inversion occurs at the top of a bull market only about ½ of the time. So, the stock market could continue to rise for the next 12-15 months, or the peak may have been on July 26. No one can know that. And remember, a “recession” is not the same as a “correction,” just like the “economy” is not the “stock market.” They are intertwined, to be sure, but not the same. So, even if a recession never comes, we could get a stock market correction. Likewise, we may not know that we are in a recession until after it has started. Also, recessions don’t have to be as frightening as the 2008 “Great Recession.” Technically, a recession is 2 consecutive quarters of GDP (economic) contraction. So, two mild quarters of contraction may go relatively unnoticed.
What we do know is that in light of these events, now is a great time to reconsider risk. Not everything is doom and gloom. The long-term trend of the market is still intact. Default insurance is not indicating trouble. Consumer confidence is high. If the Fed cuts rates again, money could come back to stocks. But, unless something changes, my plan is to use run-ups in the stock market to reduce portfolio risk. Instead of “buy the dips,” it may become “sell the rips.” I do not think this has to be done immediately. I think we will have time, and I will be reluctant to sell on pull backs. I don’t want to sell at low prices.
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