April 11, 2019 – 10am –

As you already know, I refuse to write simply to produce content. I value your time and the last thing you need is another piece of non-significant prose populating your inbox. Despite many of the recent headlines, I find little significance surrounding the inverted yield curve and the short term updates regarding China trade-talks.

I have spent considerable time pondering both and have concluded that, at the moment, they bear little influence on the economic landscape or stock market. Let me explain: by definition the yield curve is a plotted chart of interest rates whereby the X axis is the maturity and the Y axis represents yield.  As the maturity date lengthens the yield rises, thus creating a curve when all plot points are connected. In practical terms, you can consider the cost of borrowing money over the short term versus the long term. A 30 year mortgage for instance should, in theory, be a higher rate of interest than a 3-year auto loan.

The steepness of the curve, or lack thereof, is often a glimpse into the general economy, however many do not understand why. In fact, I’m convinced many pundits who speak or write on the subject matter don’t even understand this topic, but I digress.

The correlation with the economy and the yield curve is directly connected to the banking industry and the loans it makes. The primary method by which banks make money is on the interest spread between what is paid for deposits and what is received on the loans made. Let’s say, for example, that you are prone to keeping a large balance in your checking account, perhaps $100,000. Out of the bank’s incredible generosity it pays you a whopping 1% annual interest on this money, so that by year end you’ve earned an additional $1,000. In the meantime, the bank has loaned your money to a pair of newlyweds who are buying their first home.  In order to borrow this $100,000, the bank charges this couple 5% per year ($5,000) in interest, thus pocketing the $4,000 difference as revenue. This example looks at the very short end of the curve (1 year) versus the very long end of the curve (30 years) and is not inverted. Let’s maintain this example so you can have a good understanding of what’s in question. Let’s say that for some reason, whatever reason, this relationship becomes flipped around, whereby the 1 year interest rate is now above the 30 year rate. So, rather than pay you $1,000 on your $100,000 in deposit, the bank is paying you $5,000 and only making $1,000 on the loan they made to the couple to buy their home. While this would be an extreme example, it helps to understand what a bank would do in such circumstances. Do you think that bank would continue loaning money for homes? No way. If, in fact, the bank lost money on every single loan it made, it would immediately stop making loans and this would dramatically impact the housing market as a whole. The house is not sold; therefore, housing sales slump; therefore, builders stop building; therefore, contractors stop working and on and on and on.

Now, I’ve used this extreme example to explain what happens with a yield curve and how a bank might react when it inverts. So, what exactly has inverted and what exactly has happened?  Typically, when investors look at the yield spread we look at the difference between the 2 Year Treasury and the 10 Year Treasury. This is the generally accepted method by which we understand net interest margin or what a bank is making on the difference between deposits and loans. Let me make something very clear, these two time periods have NOT inverted.  While it is, and certainly has been, a very narrow relationship, I want you to understand that this is a perfect example of headlines making noise that, in my opinion, aren’t really all that relevant. So what did invert? Well, what inverted was the 3 Month Treasury Bill and the 10 Year Treasury Bond. So what’s the difference? The difference comes down to the fact that the 3 Month Treasury, or extremely short end of the curve, is primarily controlled by the Fed and can be altered very quickly. In addition, the Fed has the power to further control rates and liquidity through their own balance sheet, which is something I believe is important and will address in a bit. The point is that, while the flattening of the yield curve is certainly something to keep an eye on, I don’t find the one day of inversion something to be overly alarmed about to the point where it warrants a change in strategy.

If it isn’t the yield curve we’re hearing about it is China trade talks. This subject matter reminds me of Greece. Remember that?  When Greece first became a problem and was possibly in need of a bailout, it roiled financial markets to the core. Pundits immediately extrapolated that if Greece fell it was a matter of time until Italy, Spain, and Portugal followed. This would clearly bring down the entire EU and throw the entire global markets back into the Stone Age. Stocks were sold, headlines were printed and news was made. Just as quickly as the subject made headlines it faded away. The problems in Greece didn’t go away but the realization that their impact would take a very long time finally set in and the urgency waned.

The simple fact that we’re having trade talks with China is a positive and something that will take a very long time to navigate. It is my guess that this continues to be a very long and drawn out process; and, more than likely, will be used as a political and ballot boosting effort during a campaign for re-election. This is not something that will go away any time soon, nor do I believe we’ll wake up to a headline saying a massive agreement has been made.  What I do believe is that each country has a vested interest in success and progress. Neither country likes to have markets roiled by uncertainty. Long-term success not only is the goal but will be the outcome. I believe that over time these headlines will become less important and we’ll move to the next major issue or crisis the media deems worthy.

So, what exactly interests me here?  As is the case so often, what I find the most fascinating about our current environment and market landscape is something that isn’t all that sexy, nor does it warrant headlines. It is something, however, that I believe will be reviewed in retrospect and noted in the history books as the fuel that juiced the next Bull Run.

Until recently, the Fed used overnight lending rates as its primary tool for monetary policy. This is what is referred to when you hear about the Fed lowering or raising interest rates. This has been the norm for the last 50 years, or so, until 2009 when the Federal Reserve began buying mortgage backed securities and additional government debt, thus providing additional liquidity and expanding its own balance sheet. This ‘banker of last resort’ was unprecedented and unproven and led many, including me, to be extremely concerned about the future. Amazingly, the processed worked and helped to move us from the great recession to the great recovery. As we headed into 2018 however, the discussion naturally turned to reversing course and starting to unwind this balance sheet maneuver. This made a great deal of sense since the Fed’s purpose was not to become a long- term borrower and lender of private and public debt but, rather, a temporary backstop. The Fed laid plans to unwind this debt and it’s safe to say all hell broke loose. Many believe it was the Fed raising rates or the uncertainty surrounding China that sparked the sell-off at the end of 2018.  In my opinion, it was directly related to the course of action the Fed had set in order to unwind their balance sheet and step out of their new-found banking roll. Well, in true Fed fashion when the markets panicked, the Fed reacted and quickly started making mention that maybe unwinding wasn’t the best idea right now. Boom! The bottom was in and we were off to the races.

So why is this so important? Why do we care?  You must understand that the Fed isn’t just some small player here? It currently has over $4 Trillion, that’s a T, of mortgages and treasuries on its books. This is up from $1T in 2008, which was used to impact short term rates. Each month when around 40 – 50 Billion mature, its buying them again. The Fed has now basically become the house for a great part of the debt market AND has clearly stated its willing to play ball.

In summary, what has just transpired is an entirely new and additional method by which the Fed will control monetary policy; and, it is my opinion, that never again will we see the Fed balance sheet be reduced; but rather, over time, it will be further expanded to correlate with our national debt. Basically, what is getting no headlines at all is how the Fed not only kicked the can down the road, but found an entirely new road and a much bigger can!

Flexibility is the absolute and most critical component of long-term success in this investment business. You’ve often heard me state that when the facts change, we must change and this is precisely what has happened. It has been a fantastic year already, and it has benefited us to respect this new set of rules and the new trend in place.

There will always be bumps along the way, and it is my guess that eventually this additional method of monetary policy will create new problems. Until then, the best and only course of action is to remain properly diversified and allocated, not according to your wants but your needs and always focused on the longer term.