As O.J. Simpson’s late defense attorney Johnnie Cochran might have said, “If the yield curve inverts, you must convert”; the equities in your portfolio into cash, that is. For the first time since 2007, the Fed Funds Target Rate is above the 10-year U.S. Treasury Rate. It’s time to write the epitaph for this elongated business and market cycle, right?
Not so fast.
I understand your skepticism, for we have said time and again that this market cycle will end like all others, with the U.S. Federal Reserve (Fed) raising interest rates and the yield curve inverting. That’s true. We stand by that. Admittedly, we were intensely concerned last year when the Fed raised rates by 100 basis points and signaled additional rate hikes in 2019. Since then, however, the Fed has backed off its tightening stance. Who can blame them, with inflation climbing by a meager 1.5% over the past year?
As you’re bombarded today with scary headlines about the yield curve, remember that recessions tend to be preceded by the Federal Open Market Committee raising the Funds Rate above the 10-year Treasury Rate, and not by the 10-year rate falling below the Fed Funds Rate after the Fed has already completed its tightening cycle. You can see this in Exhibit 1 below.
In each of the modern-era recessions (1973, 1980, 1981, 1990, 2001, 2008), the green line (Fed Funds Rate) had already climbed above the black line (10-year U.S. Treasury Rate). Instead, it might be more constructive to consider periods such as the mid-1980s and mid-1990s. In the mid-1990s, the yield curve briefly inverted and the Fed countered by keeping rates generally stable over the following four years and the cycle continued.
Could this be the mid 1990s (and I don’t mean O.J. Simpson’s murder trial captivating audiences)? I think so, and here’s why.
1. Today, as in the mid-1990s, inflation has rolled over and long rates have followed in kind. Exhibit 2
2. The Fed statement in December 1995:
“Inflation has been somewhat more favorable than anticipated, and this result along with an associated moderation in inflation expectations warrants a modest easing in monetary conditions.”
3. The Fed statement in March 2019:
“In light of global economic and financial developments and muted inflation pressures, the Committee will be patient…”
4. Equity valuations today, like in the mid-1990s, are still generally reasonable, even after a multi-year bull market. Exhibit 3
Benign inflation, an accommodative Fed, and reasonable equity valuations should all serve to extend this cycle, not end it now.
Yes, the 1990s’ bull market ended badly. Still, between 1996 and 1999 the broad market gained 155% with growth strategies outperforming by as much as 5% per year. Regardless, a $100,000 investment in the S&P 500 in December 1995, when the yield curve inverted, all else being equal, is today worth $430,000.
As always, my verdict is have a plan and stick with it.
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