By Steven Van Solkema – WBI CIO
I believe the most predictive sign of a recession is an inversion in the 3-month and 10-year yields — the 3-month on the short end because that is the market’s reaction to the Fed, and what monetary policy is doing. With the ongoing worriment revolving around the Fed and trade talks, no wonder the yield curve has been inverted since May.
When the 3-month and the 10-year yield curve is inverted, this means that expectations of the future are lower. People are demanding more rate of return for what we have in current conditions. Essentially, the yield curve is signaling a softness and slowness in the underlying economy, which similarly has led to the last seven economic slowdowns. This doesn’t mean that a recession happens tomorrow, typically, there is a gap between a yield curve inversion and a recession. It could span the length of 90 days or even a year. Though with the yield curve inverted since May and stocks still high, I’m starting to have déjà vu.
What is underlying the market now is leaving me with an eerie feeling reminiscent of a pre-crisis market. I have experienced much of the market turmoil over the past couple of decades. In 2007, I predominately focused on fixed-income and mortgage-backed securities and witnessed market participants buying up the stock market even though market conditions suggested a flight-to-quality movement. Yield hungry investors were still buying into stocks even though flight-to-quality would suggest investors move their capital away from riskier investments to safer ones.
If we had seen a lowering on the short end of the yield curve, and rates were declining on the short end in anticipation of a rate cut, that would be a different story. The entire yield curve has essentially shifted down, and I believe this is quite ominous. People are hungry for yield in a low interest rate environment. Investors have obtained collateralized loan obligations, a securitized form of loans in which companies acquire individual loans on their own and have the banks tranche them into different pieces of risk. This reminds me of the mortgage-backed crisis of 2007-2010. There is currently about $1.3 trillion in this market, and it has increased at a significant rate. Again, this is eerily reminiscent and a bit unsettling.
I believe investors should temper their fear of missing out at the moment. It’s important to be cautious because the market is not making it easy for investors now. We’re either going to be trading sideways or in a very volatile situation. I would suggest that investors go for active management, and a bit of diversification in their portfolios. It’s important to look for investment opportunities that can help protect capital and as well as diversify assets. When the writing on the wall is starting to look bad, they need to know how to get out of the market quickly.
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