By Portfolio Managers Kevin Kelly & Kevin Strauss
While the media loves to discuss the gloom and doom associated with an inverted yield curve, the yield curve should be inverted whenever inflation is temporarily elevated. Covid abruptly shut down global economic activity, and then every government in the world responded to aggressively restart economic activity. Additionally, the invasion of Ukraine, as well as geopolitical tensions, led to a multi-year reset of supply chains, energy and grain supplies, and consumer spending behavior. If the global economy is the world’s largest machine by a factor of 1,000, the reality is that such a large machine can’t turn on and off quickly without major ramifications. One major result was elevated global inflation. The Federal Reserve and other global central banks had no choice but to rein in both inflation and inflation expectations because the long-term effects of elevated inflation are too destructive to tolerate. So, the Fed acted forcefully, and an inverted yield curve is the result.
The public easily forgets that the Fed has only blunt policy tools. Therefore, the Fed must use its main policy tool, the Federal Funds rate—the overnight rate at which banks lend reserve balances to each other—to stymie inflation. Whenever inflation is at a level that is unacceptable to the Fed, the yield curve inverts because the market recognizes that the Fed has to significantly raise the Fed Funds rate to temper future inflation. And since the Fed Funds rate influences short-term Treasury yields, that increase causes shorter term yields to rise relative to longer term yields. Therefore, when inflation was trending over 7% in early 2022, much higher than the Fed’s 2% long-term inflation goal, the yield curve inverted since investors knew current inflation trends were at odds with the Fed’s long-term inflation objective. Long-term Treasury rates have remained lower than short-term rates because those are influenced by long-term expectations of inflation and economic growth. It’s simple math. Notably, long-term inflation expectations, as measured by the 10-year breakeven inflation rate on Treasuries versus Treasury inflation-protected securities, is 2.25%. For context, this figure was 1.75% before Covid and peaked at over 3% in early 2022 right after the invasion of Ukraine. However, the Fed’s actions and policy comments made it clear to investors that the Fed will not waver on its 2% inflation goal, and this has kept the 10-year breakeven inflation rate near the Fed’s 2% inflation objective. The Fed must do whatever is necessary until the job of managing inflation is done. Whether inflation gets exactly to 2% is not the point; the point is that the Fed knows long-term low inflation and inflation expectations are best for the long-term growth of the economy.
Unfortunately, the inverted yield curve has caused many investors to think a long, deep recession is inevitable. While a recession can be caused by overly tight financial conditions, partially driven by the Fed, there is nothing about an inverted yield curve on its own that causes a recession. The Fed would like a ‘soft landing’ to occur in which inflation declines to an acceptable level, positive GDP growth is still achieved, and unemployment remains low. Whether this can happen depends upon a range of factors the Fed can’t directly control. For example, a decline in consumer confidence due to rising inflation or a regional banking crisis that hinders loans to small and medium businesses can each trigger a recession. Furthermore, layoffs in sectors that perhaps over-hired such as technology, higher global long-term interest rates, the unwinding of the Fed balance sheet, higher long-term expected inflation, and a higher required real return (post-inflation) on Treasuries can also contribute to a recession. To be clear, we are not saying a recession is going to be avoided. Investors just need to remember an inverted yield curve does not indicate that a deep and long-duration recession is imminent.
We encourage investors to avoid the temptation to hide their investment assets in short-term CDs, money market funds, and short-dated Treasuries. While a recession may occur for a range of reasons such as those discussed, investors need to remember the market is forward looking. Therefore, investors should not be allocating all their money to extremely safe cash-like instruments. If you pull your money out of equities to be ‘safe’, you are assuming that the market has not already priced in the recession risk. Furthermore, you are assuming that you can time the market, and you will know when to buy equities again. Furthermore, a recession does not necessarily mean the stock market will go down, and a recession definitely does not mean every stock will decline. For investors considering moving their fixed income portfolios (corporate or municipals) into even more ‘safety,’ these investors are giving up yield and significant potential total return if interest rates were to decline in a recessionary scenario. Also, these investors also lose the ability to adjust duration to market conditions and to take advantage of market dislocations. Regardless of when the next recession occurs, the yield curve at some point will uninvert. This will likely benefit a moderate duration fixed income portfolio. A long-term bond portfolio may not necessarily gain much value if a recession arrives if those yields are already reasonably priced for the long-term. Furthermore, the yield in an intermediate corporate bond portfolio is over 5.3% (based on the Bloomberg intermediate corporate bond benchmark as of 5/19/23). For those in the highest income tax brackets, the Bloomberg Muni 1-10 index currently yields over 3% (or 5-6%+ tax equivalent). For those worried about the debt ceiling, we are confident that the government will resolve it either before the default ‘deadline’ or extremely soon thereafter (by postponing the deadline). No politician wants to explain how he/she contributed to the downfall of the credit worthiness of the United States.
So, while the inverted yield curve dominates news headlines, investors should remain patient and ignore the short-term noise. A recession may come eventually, but the economy growing over the long-term is a near certainty. Profitable companies paying interest on their debt and dividends is also a near certainty. We encourage investors to focus on these longer-term positives as this will help you stay invested so that you may achieve your own financial objectives. We would encourage investors to consider moving excess cash that is paying little or no interest, such as in checking accounts, into alternatives offering significantly higher yield.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.