Monthly Brief August 2018 – A Message from Interest Rates

Monthly Brief August 2018 – A Message from Interest Rates

 

CAPITAL MARKETS
During August, US equity markets were generally driven higher by relief that (1) the real-time consequences of “trade war” rhetoric were seemingly well below previous warnings and (2) that issues within certain emerging markets had not yet spread further. Given that the amount of news-worthy information available falls far short of the content needed by the vast number of “news” providers, August seemed to reflect an investor attitude of fatigue regarding more rhetoric and speculation without much new to consider.

To recap current conditions, US earnings reports have continued to be strong and future expectations remain positive. Rising interest rates have plateaued without signs of an obvious catalyst for a significant move higher in the near-term. And, generally, international economies are experiencing positive conditions, with the exception of a handful of emerging markets. Most existing concerns are focused on policy-driven items having the potential to derail the global economic expansion, such as the actual impact of trade policy and the potential for current emerging markets’ issues to spread.

The focus on policy decisions will likely persist as the upcoming mid-term elections will be seen as motivation for action and also a potential shift of influences within congress. With the historically heightened volatility of October and September, how these issues continue to unfold will likely determine the next phase of market activity.

CHART OF INTEREST – A MESSAGE FROM INTEREST RATES
During the first quarter of 2018 investors were reminded to not get too comfortable with 2017’s favorable global equity markets. But, by April, the sharp January pullback gave way to another strong advance supported by continued healthy economic and corporate financial reports. Have risks receded, supporting further gains?

Equity investors often look to interest rates, such as the relationship between short-term and long-term US Treasuries, as one useful tool for gauging the probability of changing conditions. By way of example, a US Treasury maturing in ten years is likely to have a higher interest rate than a US Treasury maturing in two years, reflecting economic growth expectations and the premium required for the longer-term commitment. But, at times, this relationship can reverse itself, with investors receiving a higher interest rate for a shorter term investment than for the equivalent longer term option. This is commonly referred to as an inverted yield curve.

Fundamentally, this occurs when concerns begin to arise regarding the sustainability of an economic expansion. And this has been a helpful signal of increasing risk for equity investors as equity markets typically move ahead of the economy, often peaking some 6-24 months before a recession is formally declared. Simply put, if investors believe an economic expansion is coming to conclusion, equity markets respond well before an official recession begins.

With this in mind, an interesting comment was recently made by the St Louis Federal Reserve:

… the consumer price index (CPI) is no longer the most popular chart series. Recently, the series describing the difference between the 10-year and 2-year treasury constant maturity rates has jumped into the top spot. The new popularity seems due to the possibility of an inverted yield curve.*

The referenced chart is included here and depicts the relationship between longer term and shorter term interest rates, with readings below zero representing an inverted yield curve. Increasing investor interest in the message of the yield curve certainly highlights growing attention to what might derail the post-financial crisis bull market. And, should the yield curve invert, one popular gauge will be flashing a warning sign of heightened risks.

*Source: Federal Reserve Bank of St. Louis, The Fred Blog post, August, 27, 2018: What’s Up (or down) with the yield curve?

James Ferrin, CFA
Chief Investment Officer

 

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