Not since the Great Recession has there been more talk about the Federal Reserve, interest rates, and bond markets than during this past year. Since 2015, the Fed has been on a steady pace of interest rate hikes, and those changes have made themselves known with meaningful price changes in bonds this year. Coupled with stock market volatility, this has made for a divisive market for investors.
There has been some interesting events and news in the bond markets in the last few weeks that bear a moment to consider. I must tip my hat to the Fed for their transparency and openness to share their thoughts and intentions. They are not always plainspoken by any means, but long gone is the cryptic eco-babble of the Alan Greenspan regime that required a thesaurus, Rosetta Stone, and a fair amount of guess work to decipher the messages.
This week the Fed will meet and determine, among other things, whether another rate increase is warranted. It has been widely telegraphed by the Fed that they will increase rates, and most investment professionals believe the same. And, by extension, they have already priced an increase into the market.
However, what has changed in the last thirty days is the message that the Fed may slow the pace of hikes going into 2019. Their indication, as of a few months ago, was that we would see another three rate hikes in the new year. Their message now is more sanguine, with talk of them skipping a hike (or two) next year.
While the economy has a lot to be happy about (unemployment is low and inflation is in check), the long bull run we have experienced since 2010 is showing fatigue. This is giving pause to the Fed and rightly so. They certainly do not want to choke out a growing economy. However, the Fed needs those hikes to put more arrows in their quiver for the next recession. And that leads to a recent announcement.
CHANGE IN THE TARGET
On November 30th, the Fed announced it will conduct a yearlong review of its monetary policy tools. Good for them! It’s smart for any institution or business to review their policies of how they conduct business and their effectiveness. What this announcement underscores is the challenge the Fed faces.
The Fed is concerned about the neutral rate. The neutral rate is the interest rate level where an economy will keep plugging along without sparking inflation. Right now, that rate is low. Really low. Estimates are in the range of 0% to 1.5%, and is expected to stay there because of our aging population and mature economy.
The low neutral rate hamstrings the Fed because they cannot afford to raise interest rates too much before they stall the economy. As mentioned before, they really do want to increase the rates because interest rates are their most effective weapon against downturns. The concern is with interest rates as low as they are now (and despite the years of steady increases), they may not have enough gas in the interest rate tank to reduce rates effectively.
What we may find a year from now is that the Fed will no longer target the inflation rate when it comes to interest rate policy. They could choose another “gold standard” that gives them other options to effect change. We may also expect them to utilize nontraditional ways of market stimulation in the future, like they did to battle the Great Recession.
INVERSION OF THE YIELD CURVE
In economic and investment forecasting the closest thing to a “sure thing” is an inversion in the yield curve. An inversion in the yield curve is when short term interest rates are higher than long term rates. Under normal circumstances the opposite is true. Interest rates in the short term are low and gradually increase the further out in time you go. In other words, short term cash (or borrowing) is safer and costs less.
An inversion of the yield curve has preceded every recession in the last 50 years. Every single one. Last week, the yield curve inverted during intraday trading. Let’s not sound the alarm just yet. This occurred during the trading day and the bond market did not end with an inversion. Also, the inversion took place between three-year and five-year treasuries. This is not the spread economists typically look to. The predictive spread is between the two- and ten-year treasury, which maintained its normal pattern – it did not invert.
My intent is not to panic anyone. Even if we experienced a “true” inversion last week, it does not tell us when a recession might occur. Historically, an inversion can precede a recession by six months and up to 2 years. However, the reality is that the yield curve is quite flat (and has been for some time), and this temporary blip bears attention and a close eye on things to come.
Investment markets are ever changing and these are just a few items we are discussing and monitoring. We remain conservative in our allocation to bonds, focusing on short-term bonds and high quality. But we may be nearing a time when our strategy may change.