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April 4th, 2022
Author: SteelPeak Wealth – Institute of Portfolio Management
Last week, stocks continued to rebound from the recent correction triggered by the war in Ukraine. The S&P 500 gained 0.3%, while the Nasdaq rose 1%. Thursday marked the end of a challenging quarter for investors and many asset classes were down since the beginning of the year. Our market dashboard (below) highlights the returns across various asset classes. We also had a flurry of economic data last week spanning inflation, labor markets, and manufacturing. As the markets absorbed the latest data, the bond market sent a warning sign as part of the yield curve inverted prompting the business media to talk up the possibility of a coming recession.
The US economy added 431K new jobs in March. While this was below the average analyst estimate of 490K, it was enough to push the unemployment rate down to 3.6%. Since 1970, the unemployment rate has rarely fallen below 4% suggesting there is little slack in the labor market. Additionally, there are more than 11 million job openings, an all-time high, as compared to 1.3 million individuals collecting unemployment benefits, a 50-year low. The lack of supply in the labor market is causing upward pressure on wages which rose 5.6% over the last 12 months.
Higher wages are providing consumers with more spending power, but unfortunately, it comes at a time when supply chains are still strained by the pandemic, and war has broken out in Eastern Europe. Rising prices have caused inflation to rise 7.9% over the last year. Ironically, while we celebrate the fastest wage growth in more than 40 years, when adjusted for the rising cost of living, real wages are falling. The chart below shows the annual change in average hourly earnings adjusted for inflation.
To address the rising cost of living, the Fed is quickly rolling back their accommodation for the economy. Last month, the Fed stopped buying bonds in the open market and raised interest rates by a quarter percent. In addition, the Fed hints at policy moves well in advance to enable markets to price those moves in gradually. The Fed is expected to raise rates six more times this year and begin shrinking its balance sheet as soon as next month. Financial markets are pricing in that the Fed will act decisively and be able to bring inflation back to their 2% target.
In response to Friday’s jobs report, short-term interest rates rose sharply while longer-term rates rose only modestly. The yield on the 2-year treasury bond rose 16bps (or 0.16%) to closed at 2.44%, while the yield on a 10-year treasury bond closed at 2.38%. An inverted yield curve occurs when short-term rates exceed long-term rates, which typically occurs prior to economic recession. That said, like everything in finance, it is rarely that simple, and the devil is often in the details. But first, what is the yield curve?
The yield curve refers to different interest rates offered on US treasury securities with varying maturities. Under normal circumstances, the yield curve is upward slopping with longer maturities offering higher rates than shorter maturities. The higher yield on a longer-term bond compensates investors for lending their money to the government for a longer period. Below is a chart of the yield curve as of Friday (black line), and what it looked like a year ago (gray line).
The interest rate on treasury securities is often considered the “risk-free” rate because it is extremely unlikely that the US government will default on its obligations. As a result, these rates are often the benchmarks for all types of loans—e.g., mortgages, auto loans, commercial loans. The shape of the yield curve can also have a big impact on the profitability of lending. Banks effectively borrow money from savers at short-term rates via savings accounts and CDs and lend that money out to borrowers in the form of mortgages and auto loans, etc. As short-term rates rise and long-term rates move closer together, lenders have less incentive to make new loans as their profit margin on new loans is often smaller. This leaves less of a cushion to absorb defaults, and as a result, banks become more selective on who they lend money to.
Technically, a yield curve can be constructed by comparing the interest rate of any two maturities. However, many economists point to the “10-year minus 2-year” or the “10-year minus 3-month” as the most important measures for future economic activity. As the chart above shows, the yield on 2-year treasury bonds rose above the yield on 10-year treasury bonds over the last year. However, the yield on the 3-month treasury bond continues to be well below the yield on the 10-year treasury bond. Below we show both curves dating back to 1982. While one yield curve has inverted, the other has steepened.
To illustrate what the “traditional” inverted yield curve looks like, below we added the curve from February 2007 (red line) alongside the periods previously shared. While the current yield curve is currently “flatter” than it was a year ago, it is clearly not as inverted as it was leading up to the 2008 Financial Crisis.
It might seem counter intuitive to invest in a 30-year bond when a shorter maturity offers a higher yield. However, the investor who opts for a 2-year bond at 2.4% will have to reinvest their capital in 2 years when their bond matures. There is a risk that interest rates will be lower in two years, this is called re-investment risk. Alternatively, the investor who opts for the 30-year bond at 2.4% effectively locks in their return for the full 30 years and eliminates that reinvestment risk. In short, a flat or inverted yield curve implies that bond market participants expect short-term rates to be lower in the future. The market expects economic growth to decelerate from its current pace, which should bring down inflation, and thus the Fed won’t need to raise rates as much.
On Friday, updated data was made available by the Institute of Supply Management (ISM) on the ISM Manufacturing Purchasing Managers Index (ISM Manufacturing). The survey shows purchasing managers are a little less optimistic today than they were over the last 12 months. Below we show the ISM Manufacturing (black) and New Orders Indexes (blue) since 2000. These two measures of the economy appear to be in sync with the bond markets expectation of slowing growth. While both indices are declining, but not at the levels witnessed during the 2008 Financial Crisis or the 2020 pandemic.
In the coming months, financial markets will be keenly focused on the Fed’s efforts to slow the economy to reduce inflation. Inflation for the month of March will not be released until April 12th and it is expected to be a big number as gas prices spiked during March. The big question is whether March will be the peak for inflation. Unfortunately, we will not know for at least several months, but will continue to watch closely.
T I P O F T H E W E E K
When setting up a home based business, be sure to research if your local zoning regulations permit it. The Small Business Administration’s website has an overview (Zoning Laws for Home-Based Businesses).
THE WEEK AHEAD: KEY ECONOMIC DATA
Monday: Factory Orders.
Tuesday: Institute for Supply Management (ISM) Services Index.
Wednesday: Federal Open Market Committee (FOMC) Minutes.
Thursday: Jobless Claims.
Source: Econoday, April 1, 2022
The Econoday economic calendar lists upcoming U.S. economic data releases (including key economic indicators), Federal Reserve policy meetings, and speaking engagements of Federal Reserve officials. The content is developed from sources believed to be providing accurate information. The forecasts or forward-looking statements are based on assumptions and may not materialize. The forecasts also are subject to revision.
THE WEEK AHEAD: COMPANIES REPORTING EARNINGS
Wednesday: Levi Strauss & Co. (LEVI).
Thursday: Conagra Brands (CAG).
Source: Source: Zacks, April 1, 2022
Companies mentioned are for informational purposes only. It should not be considered a solicitation for the purchase or sale of the securities. Investing involves risks, and investment decisions should be based on your own goals, time horizon, and tolerance for risk. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. Companies may reschedule when they report earnings without notice.
Q U O T E O F T H E W E E K
“Imagination is the highest kite that can fly.”
T H E W E E K L Y R I D D L E
What do a shark, a zipper, and a comb all have in common?
LAST WEEK’S RIDDLE: New furniture will be delivered to your office on the day before five days from the day after tomorrow. If today is August 18, when will the furniture arrive?
ANSWER: August 24.
SteelPeak Wealth –
Institute of Portfolio Management
For more financial news and resources, visit our Insights page ⇒