Are Interest Rates Signaling a Recession?

January 31, 2023 — Sam H. Fawaz

According to Investopedia, the yield curve shows the relationship between bond yields (the interest rates on the vertical axis) and bond maturity (the time on the horizontal axis).

Long-term bonds generally provide higher yields than short-term bonds because investors demand higher returns to compensate for the risk of lending money over an extended period. Occasionally, however, this relationship flips, and investors are willing to accept lower yields in return for the relative safety of longer-term bonds. This is called a yield curve inversion because a graph showing bond yields in relation to maturity is essentially turned upside down.

Imagine going to the bank and being told that a 1-year certificate of deposit yields 4.0%, but the 5-year CD only yields 3.0%. Few people would lock up their money for five times as long and earn a lower rate. This is an example of a yield inversion.

A yield curve could also apply to any bonds that carry similar risk, but the most studied curve is for U.S. Treasury securities, and the most common focal point is the relationship between the two-year and 10-year Treasury notes. Although Treasuries are often referred to as bonds, maturities up to one year are called bills, while maturities of two to 10 years are called notes. Only 20- and 30-year Treasuries are officially called bonds.

The two-year yield has been higher than the 10-year yield since July 2022, and beginning in late November, the difference has been at levels not seen since 1981. The biggest separation in 2022 came on December 7, when the two-year was 4.26%, and the 10-year was 3.42%, a difference of 0.84%. Other short-term Treasuries have also offered higher yields;  the highest yields in early 2023 were for the six-month and one-year Treasury bills. (1) 

Predicting Recessions

An inversion of the two-year and ten-year Treasury notes has preceded each recession over the past 50 years, reliably predicting a recession within the next one to two years. (2)  A 2018 Federal Reserve study suggested that an inversion of the three-month and ten-year Treasuries may be an even more reliable indicator, predicting a recession within about 12 months. (3) The three-month and ten-year Treasuries have been inverted since late October 2022, and in December 2022 and early January 2023, the difference was often greater than the inversion of the two- and 10-year notes. (4)

Weakness or Inflation Control?

Yield curve inversions do not cause a recession; rather they indicate a shift in investor sentiment that may reflect underlying economic weakness. A normal yield curve suggests investors believe the economy will continue to grow and interest rates will likely rise with the growth. In this scenario, an investor typically would want a premium to tie up capital in long-term bonds and potentially miss out on other opportunities in the future.

Conversely, an inversion suggests that investors see economic challenges that are likely to push interest rates down and typically would instead invest and lock in longer-term bonds at today’s yields. This increases demand for long-term bonds, driving prices up and yields down.

Note that bond prices and yields move in opposite directions; the more you pay for a bond that pays a given coupon interest rate, the lower the yield will be, and vice-versa.

The current situation is not so simple. The Federal Reserve has rapidly raised the benchmark federal funds rate (short-term) to combat inflation, increasing it from near 0% in March 2022 to 4.50%–4.75% today. The fed funds rate is the rate charged for overnight loans within the Federal Reserve System.  The funds rate directly affects other short-term rates, which is why yields on short-term Treasuries have increased rapidly. The fact that 10-year Treasuries have lagged the increase in the federal funds rate may mean that investors believe a recession is coming. But it could also reflect the confidence that the Fed is winning the battle against inflation and will lower rates over the next few years. This is in line with the Federal Reserve’s (The Fed) projections, which see the funds rate peaking at 5.0%–5.25% by the end of 2023 and then dropping to 4.0%–4.25% in 2024 and 3.0%–3.25% in 2025. (5)

Inflation has been slowing somewhat in October-December, but there is a long way to go to reach the Fed’s target of 2% inflation for a healthy economy. (6)  The fundamental question remains the same as it has been since the Fed launched its aggressive rate increases: Will it require a recession to control inflation, or can it be controlled without shifting the economy into reverse?

Other Indicators and Forecasts

The yield curve is one of many indicators that economists consider when making economic projections. Among the most closely watched are the ten leading economic indicators published by the Conference Board, with data on employment, interest rates, manufacturing, stock prices, housing, and consumer sentiment. The Leading Economic Index, which includes all ten indicators, fell for nine consecutive months through November 2022. Conference Board economists predict a recession beginning around the end of 2022 and lasting until mid-2023. (7) Recessions are not officially declared by the National Bureau of Economic Research until they are underway. The Conference Board view would suggest the United States may already be in a recession.

In The Wall Street Journal’s October 2022 Economic Forecasting Survey, most economists believed the United States would enter a recession within the next 12 months, with an average expectation of a relatively mild 8-month downturn. (8) More recent surveys of economists for the Securities Industry and Financial Markets Association and Wolters Kluwer Blue Chip Economic Indicators also found a consensus for a mild recession in 2023. (9)

For now, the economy appears strong despite high inflation, with a low December 2022 unemployment rate of 3.5% and an estimated 2.9% 4th quarter growth rate for real gross domestic product (GDP). Nonetheless, the indicators and surveys discussed above suggest an economic downturn in the next year or so. This would likely cause some job losses and other temporary financial hardship, but a brief recession may be the necessary price to tame inflation and put the U.S. economy on a more stable track for future growth.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so are your financial plan and investment objectives.

(1), (4) U.S. Treasury, 2023

(2)  Financial Times, December 7, 2022

(3) Federal Reserve Bank of San Francisco, August 27, 2018

(5) Federal Reserve, 2022

(6) U.S. Bureau of Labor Statistics, 2022

(7)  The Conference Board, December 22, 2022

(8) The Wall Street Journal, October 16, 2022

(9) SIFMA, December 2022

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Higher Interest Rates: One and Done or More to Come?

December 22, 2016 — Sam H. Fawaz

We all know that we’re paying more for almost everything these days. Everything, of course, except money. Interest rates have been at historical lows for more than eight years, even though the economy has steadily improved over this period.

So anybody who was surprised that the Federal Reserve Board (A.K.A. The Fed) decided to raise its benchmark short-term interest rate last week probably wasn’t paying attention.  The U.S. economy is humming along, the stock market is booming and the unemployment rate has fallen faster than anybody expected.  The incoming administration has promised lower taxes and a stimulative $550 billion infrastructure investment.  The question on the minds of most observers is: what were they waiting for?

The rate rise is extremely conservative: up 0.25%, to a range from 0.50% to 0.75%—which, as you can see from the accompanying chart, is just a blip compared to where the Fed had its rates ten years ago.

federal-funds-rate-2016-12-16

The bigger news is the announced intention to raise rates three times next year, and move rates to a “normal” 3% by the end of 2019—which is faster than some anticipated, although still somewhat conservative.  Whether any of that will happen is unknown; after all, in December 2015, the Fed was telegraphing four rate adjustments in 2016 , before backing off until now with just this one. Personally, I believe that three interest rate increases in 2017 will prove inadequate, especially if current signs of inflation intensify next year.

The rise in rates is good news for those who believe that the Fed has intruded on normal market forces, suppressed interest rates much longer than could be considered prudent, and even better news for people who are bullish about the U.S. economy.  The Fed may have been the last remaining skeptic that the U.S. was out of the danger zone of falling back into recession; indeed, its announcement acknowledged the sustainable growth in economic activity and low unemployment as positive signs for the future.  However, bond investors might be less pleased, as higher bond rates mean that existing bonds lose value.  The recent rise in bond rates at least hints that the long bull market in fixed-rate securities—that is, declining yields on bonds—may finally be over.

For stocks, the impact is more nuanced.  Bonds and other interest-bearing securities compete with stocks in the sense that they offer stable—if historically lower—returns on your investment.  As interest rates rise, the see-saw between whether you prefer stability or future growth tips a bit, and some stock investors move some of their investments into bonds, reducing demand for stocks and potentially lowering future returns.  None of that, alas, can be predicted in advance, and the fact that the Fed has finally admitted that the economy is capable of surviving higher rates should be good news for people who are investing in the companies that make up the economy. That’s not to say that the prospect of more interest rate hikes won’t cause volatility in the stock markets.

So there may be a lump of coal on the list for over-exuberant investors in the year ahead. Although the current weight of evidence points to a continuation of this economic recovery, pressures that have been synonymous with trouble in past cycles have been developing. Wage and commodity (oil, raw materials) price increases may be rising faster than anticipated, and the Fed could easily fall behind in their efforts to keep inflation in check.

The bottom line here is that, for all the headlines you might read, there is no reason to change your investment plan as a result of a 0.25% change in a rate that the Fed charges banks when they borrow funds overnight.  There is always too much uncertainty about the future to make accurate predictions, and today, with the incoming administration, the tax proposals, the fiscal stimulation, and the real and proposed shifts in interest rates, the uncertainty level may be higher than usual.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:

http://www.businessinsider.com/fed-fomc-statement-interest-rates-december-2016-2016-12

http://www.marketwatch.com/story/fed-to-hike-interest-rates-next-week-while-ignoring-the-elephant-in-the-room-2016-12-09

http://www.reuters.com/article/us-usa-fed-idUSKBN1430G4

http://www.usatoday.com/story/money/personalfinance/2016/12/15/fed-rate-hike-7-questions-and-answers/95470676/?hootPostID=32175354f7440337d62a767b3db92c68

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

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Rate Hike Hype

December 15, 2015 — Sam H. Fawaz

While I’m still a tad skeptical, we will almost surely see the U.S. Federal Reserve Board (Fed) start the long process of ending its intrusion into the interest rate markets, by allowing short-term rates to rise starting on Wednesday. It will be the first time the Fed has raised rates since 2006, and for some it will mark the beginning of the final chapter of the Great Recession.

Since 2008, as most of us know, returns on short-term bonds have been at or near zero percent, which is a consequence of the Fed keeping the Federal Funds rate—the rate at which it will lend banks virtually unlimited amounts of money, short-term—at 0.125%. The average Fed Funds rate has historically been 3.5% to 4.0%, so this is a considerable amount of stimulus.

At the same time, the Fed has purchased more than $3.5 trillion worth of Treasury securities and home mortgage pools as part of its quantitative easing (QE) programs, bidding aggressively against much smaller buyers, which is another way of saying: forcing the rates on these bonds down closer to zero.

Pulling back out of these interventions is going to be tricky, in part because shifts in interest rates have a direct impact on a still-fragile U.S. economy (higher rates mean higher borrowing costs, potentially less corporate investment and lower profits), and even trickier because we don’t know how investors will react. In the past, the markets have panicked at the mere mention of a cutback in Fed involvement, and (more recently) have also risen on the same news, presumably because people drew encouragement from the confidence the Fed was showing in the strength and resilience of the U.S. economy.

There are also some tricky mechanical problems. The central bank will try to control the extent that short-term rates rise and fall by raising the interest it pays to banks for the reserves held at the Fed, and also cautiously raising the amount it pays money market funds for short-term trades known as “reverse repurchase agreements.” The mechanics are highly technical and complicated—and still unproven, although there are reports that the Fed has been conducting tests for the past two years.

As the markets react, either upwards or downwards, there are a few things to keep in mind. First, despite the headlines soon to be blaring from every financial section of every newspaper in the country, the rate is expected to move very modestly from .125% to .375%—clearly a small first step in a long journey toward the long-term average. After each step—prominently including this one—the Fed will evaluate the consequences before deciding to make future changes. If the economy slows, or if there are signs that inflation is falling below the Fed’s 2% annual target, it could delay the next move by months or even years. That caution greatly reduces the danger of any kind of serious economic pullback.

It’s also worth noting that the Fed has announced no plans to sell the nearly $4.2 trillion worth of various bonds—including the aforementioned Treasuries and mortgages—that it owns. At the moment, the bank is simply rolling over the portfolio, meaning it reinvests $21 billion a month as bonds mature. Eventually, most observers expect the reinvestment to stop and the Fed to allow the huge bond holdings to mature and fall off of its balance sheet. The fact that this is not being done currently reflects the exquisite degree of caution among Fed policymakers, who don’t want to rock the boat too fast or too hard.

Finally, some have wondered about the future of mortgage interest rates as the Fed begins a cautious exit from the bond markets. Interestingly, recent history shows that mortgages haven’t been especially influenced by changes in the benchmark rate. The last time we saw extremely low interest rates, after the tech bubble burst in the early 2000’s, the Fed brought its Fed funds rate down to 1%. It began raising rates by 0.25% a quarter starting in the summer of 2004, but over the next four months, the 30-year fixed-rate mortgage actually fell from 6.3% to 5.58%. By the time of the last increase in the summer of 2006, mortgage rates were running at 6.68%, just a half-percent higher than they had been at the previous Fed funds rate low.

Nobody knows exactly what to expect when the announcement comes on Wednesday, but you can look for the investment markets to bounce around a bit more than usual, and economists—including the teams employed by the Fed—to examine every scrap of data about the impact on the economy over the next quarter. At that time, Fed policymakers will face another decision, and there is no reason to expect them to be less cautious than they have been recently. For many of us, the rate rise should be reason for celebration, a sign that the long recession and period of economic uncertainty is finally starting—carefully—to be put in our rear view mirror.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

https://www.washingtonpost.com/news/where-we-live/wp/2015/12/14/what-a-fed-rate-hike-could-mean-to-mortgage-borrowers/

https://www.washingtonpost.com/news/wonk/wp/2015/12/14/the-federal-reserve-will-likely-raise-interest-rates-this-week-this-is-what-happens-next/

http://www.usatoday.com/story/money/2015/12/14/this-week-december-13/77155714/

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

Posted in American Economy, Financial Planning, General, investing, retirement planning, Stock Market. Tags: , , , . Leave a Comment »

Interest Rates: What’s the Connection to Your Portfolio?

April 27, 2015 — Sam H. Fawaz

When it comes to interest rates, one thing’s for certain: What goes down will eventually come up.

The federal funds rate — the rate on which short-term interest rates are based — has varied significantly over time. It’s a cycle of ups and downs that can affect your personal finances — your credit card rates, for example. But what about less familiar effects, like those that interest rate changes can have on your investments? Understanding the relationship between bonds, stocks, and interest rates could help you better cope with inevitable changes in our economy and your portfolio.

Bond Market Mechanics

Interest rates often fall in a weak economy and rise as it strengthens. As the economy gathers steam, companies experience higher costs (wages and materials) and they usually borrow money to grow. That’s where bond yields and prices enter the equation.

What is yield? It’s a measure of a bond’s return based on the price the investor paid for it and the interest the bond will pay. Falling interest rates usually result in declining yields. As rates spiral downward, businesses and governments “call” or redeem the existing bonds they’ve issued that carry higher interest rates, replacing them with new, lower-yielding bonds. Why? To save money. (A homeowner refinances his or her home at a lower mortgage rate for the same reason.)

Interest rate changes affect bond prices in the opposite way. Declining interest rates usually result in rising bond prices and vice versa — think of it as a seesaw relationship. What causes this change? When interest rates rise, investors flock to new bonds because of their higher yields. Therefore, owners of existing bonds reduce prices in an attempt to attract buyers.

Investors who hold on to bonds until maturity aren’t concerned with this seesaw relationship. But bond fund investors may see its effects over time.

Evaluating Equities

Interest rate changes can also affect stocks. For instance, in the short term, the stock market often declines in the midst of rising interest rates because companies must pay more to borrow money for expansion and capital improvements. Increasing rates often impact small companies more than large, well-established firms. That’s because they usually have less cash, shorter track records, and other limited resources that put them at higher risk. On the other hand, a drop in interest rates may result in higher stock prices if corporate profits increase.

So why do some stocks increase in value even as interest rates rise, or vice versa? Because industry or company-specific factors — such as the development of a new product — can impact stock prices more than rate changes.

Taking Action

Is there anything an investor can do when faced with interest rate uncertainty? You bet. Although you can’t change interest rates, you can assemble a portfolio that can potentially ride out the inevitable ups and downs. Risk reduction begins with diversifying your investments in as many ways as possible.

Let’s start with equities. Consider investing across different sectors, because no one knows which of today’s industries will fuel the next expansion. Also be aware that some sectors — such as energy — are more economically sensitive than others, which can lead to increased volatility. Additionally, consider stocks or stock mutual funds that invest in different market caps (sizes) and have different investing styles, such as both value and growth investing.

On to fixed-income investments: Do your bond funds hold bonds of different maturities — short, medium and long-term — and types, such as government and corporate? Different types of bonds react in their own way to interest rate changes. Long-term bonds, for instance, are more sensitive to rate changes than short-term bonds.

Interest rates will always fluctuate in response to economic conditions. Rather than trying to guess the Federal Reserve’s next move, why not concentrate on creating a portfolio that will serve your needs well — no matter which way rates go?

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Posted in estate planning, Financial Planning, retirement planning. Tags: , , . Leave a Comment »
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