Page 22 - NC Triangle Vol 6 No 5

PATRICK H. YANKE, CFP | Financial Signal of Impending Doom?
IfI had to choose one signal in- vestors are watching closely right now, it would be the yield curve. is curve shows the interest paid at di erent durations of debt. On the short end of the curve are in- struments like bank deposits, money markets, and CDs. On the long end
are 10- to 30-year bonds.
Generally speaking, investors take
greater risk when investing in long- duration bonds. Over a long time, a debt issuer may develop nancial troubles and change their credit rat- ing. Long duration investors su er the ravages of in ation which increases the cost of living on a geometric scale while their bonds pay simple interest. If bonds are sold prior to maturity, in- vestors may receive more or less than the initial investment.
POSITIVE AND NEGATIVE
YIELD CURVES
A “positive” yield curve is where bonds on the long end of the curve pay more interest than those on the short end. Investors should be re- warded for taking on greater risks in longer duration securities.
A “negative” yield curve (or in- verted) has short-term debts paying higher interest than long-term debts.
When we hear the Federal Reserve is raising their Fed Funds Rate, this has an in uence on short-term debt instruments. Since short-term bonds mature frequently, they adjust rapidly to rising interest rates.
Long-term rates are largely driven by supply and de- mand in secondary markets (invest- ment markets). When there is
greater demand for bonds, values rise and interest rates fall. When there is less demand for bonds, values fall and interest rates rise. ere is an inverse relationship between interest rate movements and xed-income prices. Bond prices and yields are subject to change based upon market conditions and availability.
Strong demand for bonds has kept longer-duration interest rates low. Part of this demand is fueled by Baby Boomers (in or near retirement) increasing their asset allocation to xed-income. Another source of de- mand is investors positioning portfo- lios to a more conservative posture as the current economic expansion ages.
While the Fed has been steadily increasing their short-term rates, the investment dynamics on the long end of the curve have kept long-term rates steady. is combination is pushing the market toward a negative yield curve.
PREDICTOR OF
RECESSIONS
Why are investors concerned about a negative yield curve? is indicator has been a fairly reliable predictor of recessions. Over the most recent 35 years, it preceded each of three reces- sions. Going back further than that, inversions preceded the past seven re- cessions with two false positives.
It’s important to recognize what is normally happening when the yield curve inverts. e economy is nor- mally coming to the end of an ex- pansion cycle. e Fed tightens rates on the short-end of the yield curve to combat rising in ation in a heat- ing economy. Raising short-term borrowing rates tend to “cool” eco-
nomic growth. On the long end of the curve, investors increase portfo- lio allocations to bonds recognizing that market trends may be preparing to reverse. ese are actions taken in anticipation of an anticipated slow- down or recession. e increased de- mand for bonds pushes up valuations and reduces yields.
e current economic scenario is more like the false positives in his- tory than the “normal” inverted yield curves preceding recessions. Al- though the Fed Funds Rate has risen and will likely rise more, it is nowhere near its usual “tight” level near the end of an economic expansion. Long- term rates also remain at historic lows due to lingering fears from the last recession. As the current economic cycle continues, the anticipation of the next recession grows.
Where are we in the economic cycle? If you believe, as I do, that the economy’s recent decade of below-av- erage growth is blossoming into more average growth rates (from below 2%/ yr to 3-4%/yr), you may see a current negative yield curve as another false positive. On the other hand, the pre- dictive accuracy of this signal may be a self-ful lling prophecy as investors shi assets in a protective mode.
While markets tend to follow the economy in the long-term, short-term market moves are generally driven by psychology. If investors believe this signal of impending recession, shi - ing investment dollars may cause a bear market in the short-term. Only time will tell. I recommend careful consideration of all market condi- tions rather than xation on a single indicator.
Patrick Yanke is a Raleigh nancial planner with a national business. He delivers newsletters and speaking programs on a wide range of nancial topics and regularly presents at the NCBA and NCAJ on nancial topics. Opinions expressed here are Patrick Yanke’s and not necessarily those of Raymond James. Please consult your nancial advisor if you have questions about these examples and how they relate to your own nancial situation. www. yanke nancial.com.
ATTORNEY AT LAW MAGAZINE · NORTH CAROLINA TRIANGLE. 6 NO. 5 22