April 2019 – Economic Anomalies Hint Towards Rate Cut or Recession?

By The Lerner Group on March 29, 2019

For the second time in four months the bond market saw an inverted yield curve, an anomaly that occurs when short-term interest rates paid by bonds are higher than long-term interest rates. This contradicts the normal yield curve where investors receive a maturity risk premium on their long-term bonds due to inflation and other risk factors.

This anomaly begs the question, “Why is the yield curve important?” Typically, the yield curve corresponds to the state of the economy. A normal curve tends to indicate a growing economy while, conversely, an inverted yield curve suggests a weaker economy. In fact, inverted yield curves have preceded several U.S. recessions and have been used to forecast downturns in the economy. This has rekindled the debate about a near-term recession, which had quieted in recent months.

When asked whether this yield curve signals a prolonged downturn, Janet Yellen, former Chair of the Federal Reserve replied, “It might signal that the Fed would at some point need to cut rates, but it certainly doesn’t signal that this is a set of developments that would necessarily cause a recession.” [1]

Yellen’s comments are supported by the attached graph from Bloomberg Finance depicting the current implied probability of a change in interest rates. While the probability of an interest rate hike remains at 0% throughout 2019 and into early 2020, the probability of a rate cut has steadily increased, reaching almost 60% in September 2019. An interest rate cut from the Federal Reserve would most likely reverse the yield curve inversion.

Despite uncertainty surrounding the yield curve, we remain cautiously optimistic. Leading indicators are positive with robust merger and acquisition activity and increased consumer confidence, pointing to a more upbeat market. In addition with the average rate for 30-year fixed-rate home mortgages decreasing, mortgage applications have increased 4 percent from a year earlier giving a needed boost to the housing market.

Our focus, therefore, remains on a diversified and balanced portfolio. We are monitoring the equity market closely, reducing our exposure to sectors that are underperforming while capitalizing on growth opportunities as they are presented. For example, high dividend stocks tend to offer a higher risk reward compared to bonds in this current environment. As always, we want to ensure that your investments are meeting your objectives and income needs.

We value your opinions. Please contact us if you would like to discuss your portfolio or current market conditions.

[1]
https://www.cnbc.com/2019/03/25/janet-yellen-recession-indicator-could-mean-a-rate-cut-not-a-downturn.html