A Picture is Worth a Thousand Words: What the Yield Curve Tells Us
July 2018 Market Recap
As European trade war concerns cool, domestic and international stocks restarted their march upward. US Large Cap Stocks measured by the S&P 500 Composite were up 3.72% and International stocks (MSCI World Ex-US) were up 2.46%. It’s interesting to note the outsized influence of the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) on the S&P 500 in 2018. For the first half of the year, FAANG stocks contributed a return of 3.38% while the index was up 2.65%. That means the remaining 495 stocks were DOWN a net of 0.73%.
Q2 GDP jumped to 4.1%, the best pace in nearly four years. As unemployment remains low the Fed is carefully and cautiously considering how it will raise interest rates. They want to keep inflation at its target of 2% while making sure they don’t choke off the economy. The Yield Curve is something on which they are keeping a close eye.
You’re going to be hearing more and more about the Yield Curve in the coming days. Economists and Investors have looked to the Yield Curve to understand the health of the economy and give them a sense of where the market is going. With that in mind, here are some things that you need to know about the Yield Curve.
The Yield Curve is simply a chart showing the yields of various maturities in bonds and usually describes Treasury securities. Under normal circumstances, yields will increase along with maturities as investors require compensation for holding longer term securities and taking greater risk. As short and long-term interest rates change, the shape of the yield curve changes.
Why Does a Yield Curve Flatten?
Short-term rates are most affected by the Fed and how they set the Fed funds rate. The Fed at this time is raising rates in order to keep inflation under control and make sure the economy doesn’t overheat. Long-term rates reflect investors’ expectation of inflation and the economy. A Yield Curve can flatten when future expectations of inflation fall or investors think there may be slower economic growth ahead.
On rare occasions, the Yield Curve is said to invert, meaning short-term rates have risen above long-term rates. In the past 60 years, an inverted Yield Curve has preceded every recession, with one exception.1 Understandably, many economists, including the Fed, are keeping any eye on the Yield Curve as it has been flattening recently.
What does this mean for you?
The research will tell you that although an inverted Yield Curve has often preceded a recession, the time between the inversion of the curve and the next recession is unpredictable: anywhere from 6 months to 2 years. We maintain it is best to stay properly allocated according to your unique time horizon and risk tolerance. The markets can change quickly and our mutual fund managers still hold extra cash within the fund to capitalize on opportunities as they present themselves.
We would love to have a conversation about your risk tolerance and your long-term plan if you have any questions or concerns.