2019 Second Quarter
The most influential storyline that helped boost market returns over the past three months must be the news that the Federal Reserve will closely watch the incoming economic data and “act as appropriate to sustain the expansion.” This was big news in that at the end of last year, we were scheduled to have more than one Federal Funds rate increase. Obviously, lower rates – both on the short and intermediate side of things - mean individuals and corporations won’t have to pay as much when they borrow funds so that could translate into more robust consumer and corporate spending. Over the past three months, large-cap, small-cap, foreign stocks and bonds rallied as investors digested this turn in events.
Why would the Fed make this move after months and months of 200,000+ jobs being created across the US? With inflation well below the 2% target, I believe the main reason for the change in Fed policy is the threat from something called the inverted yield curve. If you were to plot current bond maturities on a horizontal line and bond yields on a vertical line, you would typically get an upward sloping curve where short-term bonds would yield less than longer-term bonds. There is more uncertainty in the future than there is in the short-term, thus, long-term bond investors should be amply rewarded for taking on this risk with higher yields. Earlier this year short-term yields ever so slightly edged out longer-term yields when plotted on this yield curve. When this happens, it is called “an inverted yield curve” and the odds are pretty good that a recession is around the corner. As we know, the Fed controls short-term, overnight lending rates - not intermediate and longer-term rates. By decreasing the short-term rates in the near-term, you readjust the yield curve to a positive slope again and, hopefully, avoid tipping the economy into a recession. This is good news for investors and the stock market rose in approval. With all of this said, the odds are pretty good that the Fed will reduce rates by at least ¼ if not a ½ point by the end of the year.
In general, when interest rates fall, bond prices rise. If you are holding bonds with higher yields at the time of the rate decrease, your bonds will go up in value. After all, you are holding bonds with higher rates and you would be appropriately compensated should you need to sell those bonds. Moreover, US bonds are considered relatively safe due to the strong dollar that they are denominated in along with their healthy yields compared to the rest of the world. Thus, there is a lot of foreign demand for US government and US corporate intermediate and longer-term bonds. For the reasons stated above, I don’t think interest rates will be going higher for quite some time.
Our last two recessions were caused by two exploding bubbles. In the early 2000’s we had the dot-com bubble. In 2008 we had the housing bubble. I don’t see any bubbles forming at present. After all, the forward P/E ratio on the S&P 500 is still around 18 - slightly more than it was this time last year, but still within the ballpark of the long-term average of 15. While a China trade deal is still a big concern, the stock market seems to be shrugging it off.