As the summer winds down, we at Triple Summit Advisors know that you can’t wait to get to that one last summer read that has been on your list all season and that you now finally have a chance to read. If you’re anything like us, that summer read is all about the one thing that we all can’t stop thinking about – interest rate cycles. Wait, that’s not what your summer read is about? That’s not what you think about all the time? I guess that’s just us…
In all seriousness, we felt that it was time for us to revisit the topics of interest rate cycles and business cycles. Several clients have reached out to us about these topics, and we wanted to share our views more broadly. You may have seen the headlines recently about the yield curve inverting and wondered, what is that and what does that mean? We’ve written about the yield curve before in both our 2017 annual letter and 2018 annual letter, as it is the most important macroeconomic indicator that we track. We will write more about the upshot of an inverted yield curve a few paragraphs down, but first we’d like to provide a quick refresher on what these terms mean.
Source: The Wall Street Journal
In the United States, the yield curve is a graphic depiction of the interest rates of US Treasury bills and bonds at varying maturities. The yield curve in most cases is upward sloping, and this was the case a year ago on 8/29/18, as shown by the black line in the graphic above. There are many technical reasons for why the yield curve slopes upward, but fundamentally there is a common sense reason for why the interest rate at which you would lend to the government is higher for longer terms than for shorter terms. The reason is that the longer the period for which you lend money, the greater the risk there is that something will go wrong in the future and the borrower will be unable to repay. Therefore, for longer terms, you will charge everyone – including (maybe especially) the US government – a higher rate of interest. On the flip side, if you borrow money, you’ll likely pay a higher rate of interest for borrowing over a longer term than over a shorter term. If you’ve ever compared the interest rate on a 15-year fixed-rate mortgage against that of a 30-year fixed-rate mortgage, you know exactly what we mean.
The blue line in graphic above is the yield curve for US government borrowing as of 8/29/19. The curve now generally slopes downward, hence the term yield curve inversion that has been in the headlines lately. Long-term interest rates falling below short-term interest rates indicates that credit market participants expect lower interest rates in the future – so much lower, in fact, that the usual relationship between interest rates across maturities is flipped. But why would the credit markets expect that interest rates will decrease in the future? One primary reason is that market participants expect the Federal Reserve to decrease interest rates in the future in an attempt to stimulate the economy because the economy will be in a recession. In a recession, overall productivity decreases (leading to a decrease in real interest rates) and there is an excess of goods and services (leading to a decrease in inflation), thus decreasing both components of the interest rate. The credit markets are very sensitive to the economic strength of borrowers, as lenders generally have a lot to lose and not much to gain if they make loans that are not repaid in full and on time. The Federal Reserve’s own research has shown that the pattern of yield curve inversion preceding recession has played out before every recession since World War II, and we have no reason to believe that this signal is invalid this time around.
So the upshot of the yield curve inversion is this: we expect recession to start within the next 18 months. This is not a hard and fast rule, and we could easily be wrong. In fact, if you look at the first instances of historical yield curve inversions (measured here as 10Y yield minus 2Y yield) during the previous two recessions (see graph below), you will notice that a) the shape of the past yield curve inversions are different from today’s yield curve inversion, and b) the absolute level of interest rates during previous inversions was significantly higher.
Source: U.S. Department of Treasury
What does this imply about today’s environment? We don’t know. However, with history as a guide, we still view “recession within the next 18 months” as the base case scenario for the US economy. Accordingly, in the investment strategies that have the appropriate mandate, we have begun to invest more defensively. This means that in certain strategies, where appropriate, we have started to reduce our exposure to the most economically sensitive holdings. We expect to continue to reduce our exposure to these holdings in the coming months, but we admit that this process is more art than science, because – as the old Wall Street saying goes – no one rings a bell at the top. We aim to conduct ourselves as we have always attempted – with prudence and an eye to understanding risks first. This approach is intended not only to help reduce the effect of a recession and market downturn on portfolio values, but also to provide deployable funds for when opportunities arise during the tumult, confusion, and even chaos of a downturn.
We know that interest rate cycles and business cycles are complex topics and that you may have follow-up questions to the thoughts that we have shared above. As always, we invite your questions and comments and would be more than happy to discuss these topics further with you.
