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Komson: Thank you for tuning in to this episode of the Sage Advice Podcast. My name is Komson Silapachai, Vice President of Research and Portfolio Strategy here at Sage. Today we’re going to talk about the yield curve.
Last week for the first time in over a decade, the slope of the yield curve went negative or inverted. The five-year Treasury yield traded below the two-year Treasury yield the first time since June 2007. Now going back to the mid-1970s, the time from when the yield curve moves into negative territory to the start of a recession is on average about 19 months. So while inverted yield curves don't mean a recession is imminent, they do signal the looming end of an economic expansion. So what causes an inverted yield curve? An inverted yield curve is a symptom of tightening monetary conditions from the Federal Reserve. The Fed has the difficult task of keeping conditions such that the economy grows at a sustainable rate, but not so fast is to produce asset bubbles or runaway inflation.
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The Fed does this by raising short-term interest rates to the point where financial conditions become sufficiently tight to shrink the amount of credit and money in the economy, resulting in economic headwinds and the expectation for lower future growth. That doubt on future growth can manifest into a flatter yield curve and demand for longer versus shorter duration assets, which is what we've seen in the most recent tightening cycle. This is obviously not the first time that the curve has inverted, so we can use past episodes as a guide for this time. However, there is uniqueness to the cycle. As the saying goes, “history doesn't repeat itself, but it often rhymes.” The same goes for the business cycle. At the macro level, growth, inflation, and fiscal and monetary policy drive evolution of the cycle, but there are always differences from one cycle to another. The big difference for this cycle is the unwind of a massive quantitative easing program, also known as QE.
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Let's review QE by going back 10 years. During the heart of the Great Financial Crisis in 2008 after the Fed Funds rate dropped to zero, the Fed instituted the asset purchase program, QE, to stimulate the economy. And that ballooned the Fed's balance sheet from $900 billion pre-crisis to $4.5 trillion. At the peak, the purchase of financial assets resulted in a portfolio rebalance dynamic, in which lower long-term interest rates forced investors to move out into riskier and riskier asset classes to earn the same yield. Imagine you are a pension fund with a 7% liability and the Fed pushed rates lower, you'd have to go out the risk spectrum to earn the same type of yield to meet that liability -- you'd have to chase that yield. Now in that dynamic, volatility fell and remained low as investors were sure that the Fed would continue to buy bonds. So the opposite dynamic is happening today as the Fed is unwinding QE. Tightening monetary policy for the Fed includes raising interest rates and now, additionally, also includes shrinking the Fed balance sheet. This lack of buying has created a void in the marketplace as investors rebalanced into safer asset classes. For example, cash has become more attractive as investors move out of riskier asset classes to safer asset classes, such as cash. Volatility has picked up as a result, and we think as long as a Fed remains out of the markets and continues to unwind QE, volatility is likely here to stay.
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