Glenview’s Market Thoughts…
Wednesday morning the two-year to ten-year treasury yield curve inverted for the first time since 2007. An inverted yield curve occurs when short-term interest rates rise to a level higher than longer-term ones. In this case, the two-year treasury yield is a few basis points (a basis point is 1/100th of one percent) higher than the ten-year yield. Taking heed, major stock markets around the world were down over two percent on top of the increased volatility of the past few days.
Historically, recessions have occurred, on average, 22 months following a two-ten inversion. Counterintuitively, the S&P 500 has averaged a 12 percent positive return one year after a two to ten inversion, and it’s not until about 18 months after an inversion that the stock market starts to see bear market-like declines.
Why has the yield curve inverted and what does it mean? We’ve written before about the potential negative effects of the trade dispute between the U.S. and China and several seem to be playing out. Growth in the U.S. has slowed as has economic activity in many other parts of the globe. Germany and France saw their economies contract last quarter and growth in China, although the numbers can be unreliable, is undoubtedly slowing too.
Given the increasing interdependence of the global economic system, it is only natural that slowing growth among the world’s largest economies puts pressure on others. In this slow growth/contracting economic environment, central banks and large institutional investors prefer to own bonds because of their relative price stability compared to stocks. That in turn increases the price of bonds, lowering bond yields (aka interest rates) since bond prices and yields move in opposite directions. When long-term interest rates decline below short-term rates (inverts) the bond market is essentially forecasting a recession.
An inverted yield curve has practical implications for the business cycle as well. In a normal economic environment banks “lend long and borrow short,” lending at higher rates and borrowing the money to fund those loans at lower rates. The difference between the two rates—the spread—is the bank’s profit margin. The lower the spread is, the pickier banks become about who and what they will finance, making companies and individuals more likely to delay or cancel capital spending and other purchases. When that slowdown reaches the point that the economy contracts a recession occurs.
No one knows if this inversion will ultimately lead us into recession or when the next bear market will begin. Since 2017, we have been helping clients focus on whether, given the strong equity returns since 2009, they remain comfortable with their allocation between stocks and bonds. Even after the volatile last few days, major U.S. markets are within six percent of their all-time highs. As such we remain confident this is a prudent time to continue focusing on asset allocation and ensuring clients are comfortable with theirs. Maintaining that comfort level helps all of us weather inevitable market declines by focusing on long-term goals and avoiding emotional, undesirable decisions.
Thank you as always for your confidence and trust!
The Glenview Trust Company