My family just finished the third season of the Netflix series “Stranger Things” on the night before we sent my second daughter off to Purdue.
If you watched this great 1980s period sci-fi drama, set in sub-rural Indiana, you know this probably wasn’t a good idea. Hopper’s final letter about parenthood and change didn’t do me any favors managing my own strange emotions surrounding this momentous family occasion.
After the drop off, and the medium length, but long, drive home was over, however, I came back to reengage the world to find all kinds of stranger things going on in financial markets.
Perhaps much scarier than a giant fleshy crab monster who escaped the gates of hell ("Stranger Things" reference), is what’s going on with interest rates here and around the globe.
On Wednesday morning, the U.S. interest rate yield curve officially inverted. What this means is the interest rates paid on short term debt became higher than interest rates paid on longer term debt. This counter intuitive phenomenon has been manifesting in various parts of the interest rate markets for some time, but the “big one,” the two-year U.S. Treasury versus the 10-year U.S. Treasury, finally occurred early Wednesday.
The reason this is important, according to CNBC, is this particular financial market oddity has occurred preceding seven of the last nine recessions. This makes the inverted yield curve perhaps the most accurate, and certainly most widely watched, harbinger of an economic slowdown. Also, according to information on CNBC, the average length of time from an inversion in the two- to 10-year part of the interest rate markets and the start of a recession has averaged 22 months.
So, does this mean we sell everything, buy canned goods and cancel our order for the new Ford Explorer (which apparently, they can’t make enough of over there in Hegewisch)? Well, before we restart work on the back-yard bunker let’s take a breath.
If the inverted yield curve looks strange here in the U.S., then the rest of the world looks absolutely bizarre. The Europeans went to a negative interest rate policy nearly five years ago. This means some European bonds are actually assured to return less to the investor at maturity than was originally invested. And the Japanese have been manipulating their interest rate market with negative yields as well.
When other developed market economies are offering bond investors the surety of getting less capital back than was invested (negative yield), and U.S. Treasury bonds are offering a whole whopping 1.5% to 2% yield, it makes U.S. bonds look like the deal of the century.
The net result is U.S. longer-term bonds continue to attract global capital, driving bond prices higher. When bond prices rise, the yield on the bonds goes down, which appears to be a distinct possibility in this situation. The global capital markets have driven longer term interest down in the U.S.
Short term interest rates, however, are influenced directly by the Federal Reserve, which sets short term interest rate policy. After an aggressive four interest rate hikes in 2018, the markets appear to be telling the Fed that it may have gotten ahead of itself. The Fed responded by reversing course last month by lowering interest rates, and I’m in the camp that believes this trend will continue for the rest of the year.
With these things in mind, this particular inversion may be temporary, which might make it less likely to fulfill its recession prophecy. Inverted curves that last too long tend to reduce the ability for banks to make money, and therefore impact credit creation and economic growth. So, it's possible that inverted yield curves are more causation than predictive, but this topic exceeds the scope of this column.
At this point I’m going to suggest investors remain aware and once again check their portfolio risk level. I’ll make sure to keep you posted on this strange environment.
