Investment Insights: Are rates hinting at recession?

Wade Balliet
Posted by Wade Balliet
Investment Strategy

This weekly report presents insights from our Global Investment Management team.

Car being assembled in a factory full of equipmentU.S. financial markets are closed on Wednesday in memory of former President George H.W. Bush, and investors may need that time to digest the current turbulence in stock markets.

Equities jumped over a percent on Monday after President Trump tweeted that China would remove tariffs on U.S.-made cars, signaling headway in the tense U.S.-China trade dispute. That claim went unconfirmed by the Chinese government and the enthusiasm sparked by the tweet seems to be fading, and fast. The S&P 500 fell 3.24% today on renewed concern over trade and fluctuations in Treasury yields.

The yield of the 10-year Treasury continues to fall as investors flock toward safe haven assets in hopes of avoiding the current bout of volatility in stocks; the benchmark gauge ended Tuesday at 2.91%. While investors are constantly looking at the 10-year as a measure of longer term rates, the real story seems to be at the shorter end of the curve. Currently, the 3-year Treasury is yielding more than its 5-year counterpart. This may seem benign as the difference is only a couple of basis points, but this also marks an inversion in part of the Treasury curve.

Typically, these yields follow a fairly logical rule of higher yields for longer dated bonds – and a break in that order can be a harbinger for an economic slowdown. One of the most reliable and frequently used leading indicators of an economic recession is when the 2-year Treasury yield exceeds the 10-year yield. While they have yet to converge, a continued slowing in growth combined with higher rates could cause a red flag to be raised sometime next year.

The Fed will certainly be keeping a close eye on the change in bond yields ahead of its December 18-19 meeting, particularly as it is widely expected the FOMC will raise rates further during that summit. The markets have established a 74% probability of a rate hike this month, according to Bloomberg fed funds futures data, and a drop in probability for subsequent hikes in 2019. This month’s Fed meeting may turn out to be one of the most important in recent memory. Another rate hike, and any additional ones in 2019, could be enough to rein in and slow economic growth, while not proceeding with the expected hike could be a rude awakening for financial markets and may reflect a weaker economy.

At the beginning of this year, our team expected mid to high single-digit stock returns, and for equities to outperform bond markets in 2018 – this has continued to be the case most of the year. While market participants still have a pretty supportive economic landscape, the investment environment continues to focus on risk mitigation at this stage in the business cycle. The Global Investment Management team anticipates continued volatility and uncertainty on the horizon, but believes our strategies are positioned properly for this reality.

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Chart showing various market returns as of 12/3/18
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