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Fed Dead Ahead
This week marks the last Fed meeting for 2021.
If this year were an episode of Sesame Street, it would be brought to you by the word ‘transitory’ and the number ‘Planck’s Constant.’
It’s been one of those years.
The Fed’s likely to increase the pace of its asset taper while moving up its rate increase schedule, especially after last week’s 6.8% CPI reading.
Typically, we’d expect that to push Treasury prices lower, sending yields up.
And normally, that’s good for stocks.
Except this time around, the massive corporate debt overhang could take a hit when interest rates rise.
Plus, higher interest rates should force investors to reevaluate their holdings in favor of less risk.
Again, that’s how things typically work.
Yet, with most of these moves expected, the market has yet to show signs of pricing in these problems.
While pullbacks can happen when people expect them, crashes usually don’t.
That’s what makes the reaction to this week’s meeting so crucial.
Pundits on television likened the mood to markets prior to the dotcom bubble pop.
Others said it’s similar to Christmas 2018 when the Fed sent stocks spiraling lower.
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US Yield Curve Inverts
Economists grew concerned over the weekend as the yield curve did its dreaded ‘inversion.’
What is an inversion?
U.S. government bonds have maturity (expiration) dates set when they are issued ranging from one month to 30 years. Each pays a certain coupon at regular intervals.
The yield is the coupon payment divided by the price of the bond.
In normal markets, longer-dated treasuries garner higher yields as they carry more time-duration risk.
When the yields of longer-dated treasuries fall below shorter-dated ones, it’s known as an inversion.
Inversions can happen at different points in the curve such as between the 3-month and 10-year or, in this case, the 20-year and 30-year yield.
Inversions & Recessions
In the past, yield curve inversions have been harbingers for recessions.
However, it depends on which ones you look at.
The most commonly cited is the 2-year and 10-year inversion.
However, as you can see in the graph below, the line, which represents the 10-year yield minus the 2-year yield, sometimes falls below zero, signaling an inversion. Yet, that doesn’t always line up with the gray areas which identify prior recessions.
A better inversion indicator that’s been near perfect is the 10-year minus the 3-month yield.
Right now, the worry is drawn from the 20-year to 30-year yield inversion.
However, its ability to forecast recessions isn’t very good.
You can see how this portion of the curve was inverted for most of the ‘90s and multiple times before and after.
Economists believe a significant amount of market gains in the decade after the Great Recession were a direct result of the Fed’s easy-money policies.
Those same individuals see a major chunk of current gains driven by those same policies.
So, if the Fed pulls them back, what do you think is likely to happen?
The Bottom Line: Focus on the 10-year and 3-month yield inversion if you want to forecast pending recessions.
A good proxy for the 3-month yield is the SGOV ETF while the IEF works nicely for the 10-year yield.
In the meantime, consider adding inverse Treasury ETFs like the TBT or financial stocks like the XLF or KRE ETF to your portfolio which benefits from higher interest rates.