Why an inverted yield curve is disconcerting given such low interest rates. Why those low rates could lead to radical central bank policies during the next recession.
In this episode you’ll learn:
- What is an inverted yield curve and does it signal a recession is coming.
- What determines interest rates.
- What is the neutral equilibrium real rate of interest and why it matters.
- Why is the Federal Reserve considering make up strategies that allow inflation to rise up its 2% target and what is the risk.
- What can we do as investors to protect ourselves against inflation and deflation.
While we often rely on economic growth estimates by the Federal Reserve and other central bankers, the central banks don’t know everything. In this episode, host David Stein explains what the recent yield curve inversion will affect, how and why monetary policy is made, and what impacts interest rates. Even while there may be large, unknown factors in the future economy, there are practical steps you can take to cushion your portfolio and stay one step ahead of a possible recession.
What the yield curve inversion means for your portfolio
The yield curve is a graph that depicts interest rates for different terms. If you start at the left-hand side, you will see short-term rates (i.e., 30 day, 90 day, etc.) and longer-term rates (i.e., 5 year, 10 year, 30 year, etc.) as you move across the graph to the right. Recently, the 10-year Treasury bond yielded less than you can earn on cash (or the 30-day Treasury bill) at an interest rate of 2.46%. David explains that this occurrence has habitually preceded economic recessions since 1960.
What does this mean for your portfolio planning? Even though stock market peaks have consistently come with yield curve inversions, David says that it shouldn’t automatically mean you need to pull out of the stock market. Instead of retracting, we should be strategic about incrementally adjusting our portfolio. A yield curve inversion is just one of many signals that a recession is coming. It shouldn’t be the only factor taken into consideration.
How and why the policy rate is being controlled
To understand why the yield curve has inverted, we look at what influences interest rates. David explains that one of the leading factors in determining interest rates is the expectation of what short-term rates will be in the future. Short-term rates are mostly controlled by central banks. Currently, the short-term rate, otherwise known as the policy rate, is set at 2.5% while 10-year interest rates are priced at a similar to lower yield in anticipation that future short-term rates will be lower. Another factor that influences interest rates is the expectation of inflation. Finally, a third factor that influences interest rates is the term premium, which represents the additional yield investors demand to compensate for unexpected inflation or a higher than expected policy rate.
How do central banks decide where to set the policy rate? Banks endeavor to maintain a rate that provides equilibrium for employment and investment opportunity. Central bankers try to understand and anticipate the expectations and financial needs of investors and business owners. When policy rates are high, businesses have fewer options to pursue projects and expansion. When rates are low, businesses have greater spending and borrowing capacity. The trick is to create a state of equilibrium—where businesses are encouraged to expand, but not so much that it stretches the capacity of the private sector to produce, creating inflation. The problem is that the equilibrium or neutral rate of interest is unobservable, which leads to a grand guessing game among central bankers.
What central banks don’t know is keeping them in fear of the lower bound
Right now, the policy rate is 2.5%, which is low compared to other Federal Reserve tightening cycles. Yet, the Federal Reserve has stopped raising the policy rate. Why can’t the economy support higher interest rates? David explains that it is partly due to the fall in the global neutral interest rate—the equilibrium rate that stabilizes an economy. Even though it is considered unobservable, there are several factors that have contributed to a lower neutral rate of interest, including aging populations, changes in risk-taking behaviors, slower technological growth and a decline in general spending.
Another possible reason for the low neutral rate of interest is simply that central banks are keeping policy rates low and the private sector has come to expect low rates and act accordingly. The guessing game of what will happen in the economy creates a cycle, which is difficult to withdraw from. Low-interest rates encourage more borrowing and increased debt levels. It also creates an expectation of low future interest rates, which anchors the economy where it is at because interest rates are built, in part, off of expectation.
The problem central banks are having is that they need to be able to create a buffer in case of a recession. The buffer is the ability to lower interest rates low enough to encourage more borrowing and more spending in order to lift the economy out of recession. The problem is, the short-term policy rate is on hold at 2.5% leaving little room for the Federal Reserve to lower the policy rate in the future since it cannot go below 0%. Central bankers fear this 0% lower bound could lead to a situation where rates reach that level, but the economy continues to spiral downward, potentially leading to deflation (i.e., falling prices).
Bankers fear of the lower bound and potential deflation is why they have an inflation target of 2% instead of a target of no inflation. Still, the U.S. inflation rate has consistently fallen short of their goal, creating a worry for central bankers and leading them to consider more radical policies such as seeking to generate inflation above the 2% target in order to make up for prior year inflation shortfalls relative to the target. To learn more about the impact of running into the lower bound and the tools that the Federal Reserve and other central banks are using now and contemplating for the future to keep the economy stabilized, listen to the entire episode.
Protecting ourselves from the unknown
What do we do when the economic forecast is uncertain? It is important to understand that central bankers are only human—they don’t know what will happen with the economy. While their job is to act confident and foster an atmosphere of certainty and reliability, they don’t know where interest rates will be in the future, how much inflation there will be and how the economy will perform. In short, they make educated guesses, which are often wrong. So how do we protect ourselves and create portfolios that can stand the test of time? David encourages ownership of real assets to counterbalance the unknown.
Either deflation or inflation will be a reality. Since there is no current margin for error, it is vital that we diversify our portfolios to create flexibility. Exposure to gold, rental real estate, land—all of these can provide some protection when the economy takes a turn. To learn more about practical tactics you can take to expand and stabilize your portfolio, listen to the whole episode!
- [0:23] Yield curve inversion has generally led to a recession.
- [3:00] Stock market behavior during a recession.
- [5:19] Why has the yield curve inverted?
- [7:04] Understanding who controls and defines the policy rate
- [14:42] Why can’t the economy support higher interest rates?
- [20:08] Fear of the lower bound.
- [22:15] Tools to keep inflation growing.
- [25:31] What we should be doing to protect against what the central banks don’t know.
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