Gill Capital Partners March 2019 Market Commentary

What are we talking about at Gill Capital Partners?

Our Investment Committee meets regularly to review portfolio allocations, macro-economic events and our investment managers. Below are some areas that are currently top of mind within the Committee.

Inverted yield curve – What does it mean?

You may have seen recent headlines about the yield curve inverting and how that may signal that the economy is heading for a recession. Before we get into our interpretation of the current curve, we thought a quick overview would be helpful. The yield curve is a graphical representation of interest rates for a range of maturities. Shown below is a very simple depiction of a normally shaped yield curve. The yield curve shows the yield investors will earn if they lend money for a given time period. A normal yield curve reflects higher interest rates for longer maturities, which makes logical sense, as one would expect a higher rate of return to lend money for a longer period of time.

Below is a depiction of an inverted yield curve, which has historically been one of the market’s most reliable leading recession indicators. The yield curve inverts when yields on bonds with shorter maturities are higher than the yields on bonds with longer maturities.

As shown in the chart below, when 2-year U.S. Treasury bond yields exceed 10-year Treasury yields, a recession has usually followed, on average, about one year after the inversion.

A yield curve inversion occurs when investors in the bond market anticipate that the Federal Reserve will cut interest rates or stop raising them in the near term. Under these circumstances, investors are willing to accept less yield to lock up their money for a longer period of time, as they believe short-term rates will be coming down. This past Friday, the yield curve inverted ever so slightly for the first time since 2007. Is this a red flag that a recession is imminent? Or does this signal not carry the weight that it once did?

Our View:

At Gill Capital Partners, we do not make investment decision based upon any one economic indicator, nor are we market timers. We have been watching the yield curve closely for many months, and the recent inversion is one more data point that supports the more conservative portfolio positioning that we have been implementing over the past few months as we rebalance client portfolios.

It is true that the yield curve has historically been one of the most accurate tools for forecasting recessions. However, prior recessions have only happened when the curve inverted by more than ½ of one percent. The current inversion is not close to that level. Furthermore, there are many reasons to believe that the indicator may not be as valuable of a predictive tool in the current environment as it once was, and we therefore find it important to understand why the inversion has occurred and what it is telling us. We are living in unprecedented times when it comes to interest rate manipulation and monetary policy. Interest rates have been held artificially low for an extended period of time, and so it does not take much for an inversion to occur. The inversion is not a result of monetary policy that is too tight, as has been the case in past inversions and recessions. Monetary policy is far from restrictive.

The inversion is the result of rapidly shifting investor expectations after the Fed’s sudden U-turn since September on the direction of the Fed Funds rate. The bond market now believes there is a slightly better chance that the Federal Reserve’s next move may be to cut rates rather than raise them. This is dramatically different than where expectations sat just 4 or 5 months ago. The Federal Reserve is also a student of history, and has shown a willingness to adapt quickly in order to support its mandate of full employment, as evidenced by the rapid about face in its rhetoric since September.

While we take the yield curve inversion seriously, we are not yet seeing any of the other indicators that have historically accompanied an inversion prior to recessions, such as an aggressive Federal Reserve, a spike in commodity prices, or extreme asset valuations. Furthermore, the newfound lower interest rate environment will be supportive of economic growth and equities. The majority of our indicators and inputs point to a slower growth environment as opposed to a recessionary environment over the next 12-18 months. And, while a yield curve inversion has a good track record of predicting recessions, it is lousy from a timing perspective. Recessions have occurred anywhere from a few months to two years following inversions. That being said, we have been using the equity rally this year to rebalance to a more “neutral” and slightly more defensive risk position in our client portfolios. We are no longer overweight equities, but we continue to own high quality equities as part of a well-diversified portfolio, as long-term equity returns are still very compelling.

 As always, please let us know if you have any question or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.