May 2019 Newsletter

Flat Yield Curve May Help Boost Stock Market Until Reality Hits

In last month’s newsletter, I explained that the recent flattening of the yield curve might actually help the stock market in the short-term. So far, that’s proving to be true. The S&P 500 hit a new record high in April, and for the first time this year the Dow Jones Industrial Average spent an entire month over 26,000.* Naturally, some of this growth can be attributed to more good economic news coming out last month, including strong earnings reports for many companies and an early first-quarter GDP figure of 3.2%. However, in actuality, the yield curve issue is another driver, and it may continue fueling this latest short-term bull rally for many months. However the riss of an inverted yield curve could include another recession and a major market drop.

As I explained last month, the yield curve flattened in March after a misguided move by the Federal Reserve. On the same day the Fed announced it will not approve any more short-term interest rate hikes this year, it also announced plans to discontinue the unwinding of quantitative easing by September. The second announcement almost immediately caused long-term bond yields to drop—and I believe the Fed’s actions will continue to put downward pressure on long-term interest rates. That means even with short-term rates only at 2.45%, a flat or nearly flat yield curve will remain in place.

Remember, a flat or inverted yield curve occurs when long-term rates drop or short-term rates rise until they are even; in other words, an inverted yield curve is when long-term rates are lower than short-term rates. Within a week of the Fed’s announcement on March 20^th, the yield on the 10-Year Treasury rate dropped all the way to 2.39%, well below the Fed’s current benchmark short-term rate of 2.5%. The 10-Year briefly got back above 2.6% in April, but has otherwise remained around the 2.5% range ever since the Fed’s announcement, keeping the yield curve flat or nearly flat.

While I believe this situation could trigger a recession and major market correction down the road, in the meantime the stalled low-interest rate environment is forcing many everyday investors up the risk curve and into the stock market. It’s also compelling corporations to continue increasing their use of stock buybacks. I believe both these situations are driving the stock market’s recent gains as much as, if not more than, any strong new economic data, and that they may help expand the equity bubble even further in the months ahead.

Remember, a flat or inverted yield curve is economically dangerous because banks depend on having a spread between long- and short-term interest rates in order to make lending worth their while. Banks typically borrow short-term and lend long-term, and need a spread in interest rates to make a profit on those loans. If there is little or no difference between long and short-term rates, banks of all sizes could end up taking a hit and slow or even stop making loans.

In fact, many big banks have already reported that the crunch from the inverted yield curve is hurting top-line growth and forcing them to scale back their earnings forecasts for 2019.** The impact on smaller regional banks might end up being even worse, because most have less types of financial services to fuel their revenue streams. They depend on things like home and auto loans, and on having a yield curve steep enough to make money off them.

With a flat yield curve, many smaller banks end up tightening their underwriting standards and approving fewer loans. Naturally, that’s bad not only for the bank, but for the whole economy, and can start a domino effect toward recession. Fewer homes and cars could be purchased, consumers would start spending less, production falls with decreased demand, companies start laying off...on it goes. That’s how I believe this flat yield curve could quickly go from being symptom of a coming recession to being a cause. Naturally a recession would be the worst possible news for the stock market, which dropped by nearly 60% in conjunction with the last recession.

‘This Time Will Be Different’

Now, it’s possible you’ve heard or read some opinions in recent weeks about the inverted yield curve that have downplayed its significance. I have too, and can tell you that most of these arguments fall into a familiar category for financial journalism: “this time will be different.” It’s the same message you hear touted by much of the financial media whenever warning signs are mounting that the next recession and major stock market correction might be coming.

Make no mistake: historically speaking, a flat or inverted yield curve is one of the most consistently reliable of those warning signs. According to one study by the San Francisco Fed, an inverted yield curve has preceded all nine recessions that have occurred since 1955. In each case, the recession hit in the following 6 to 24 months of the yield curve’s inversion.***

Naturally, the analysts arguing that “this time will be different” always have plenty of data to support their argument. Some of it may even sound reasonable and make sense analytically. However, as I discussed in last month’s newsletter, it’s always important to make sure you don’t get so caught up in data and left-brained analysis that you ignore common sense. Common sense is what might prompt you to ask: how likely is it that this time will really be different, if each of the last nine times in the past 64 years have all been the same?

*MarketWatch.com

**“Bank Investors Face a Conundrum in an Inverting Yield Curve,” Yahoo Finance, April 23, 2019

***“One of the Most Important Recession Warning Indicators is Beginning to Flash,” slate.com, March 26, 2019

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Pacific Financial Planners, LLC is an Independent Registered Investment Advisor. Securities offered through Western International Securities, Inc., headquartered in Pasadena CA. Pacific Financial Planners, LLC and Western International Securities, Inc. are separate and unaffiliated. The material contained within are the opinions of Jerry Slusiewicz only and are neither an offer or recommendation to buy or sell any securities or strategies mentioned. You should always check with your professional financial advisor and/or tax advisor before taking any action on any of the securities or strategies contained on this site..