In the September Issue
- What is the Yield Curve?
- A Look Into Current Yield Curve Projections
- Why Short-term Rates are Rising
- How to Prepare your Investment Portfolio for a Potential Yield Curve Inversion
Is the U.S. Economy Headed Toward a Recession?
A Look at Current Yield Curve Projections and How to Prepare Your Investments for an Economic Downturn
Investors, analysts and financial advisors all use financial instruments to try and predict the future of the U.S. economy.
One instrument investors continue to monitor is the yield curve– a plotted graph representing short-term and long-term bond interest rates over varying maturities. The yield curve’s slope gives key insights into the economic outlook of an economy along with market health predictability.
*NOTE: There are several leading indicators for market health predictability. The yield curve is simply one instrument to analyze short and long-term rates.
In this month’s newsletter, we will take an inside look at current yield curve projections, potential impact on investors, and how to prepare your portfolio for an economic downturn.
What is a Yield Curve?
Before we dive head first into yield curve projections, let’s define a few key terms that are important to the discussion:
Yield Curve: A graphic illustration representing bond yields (or interest rates) of varying maturities.
2 Year Treasury Rate: Left end of the yield curve
10 Year Treasury Rate: Right end of the yield curve
Flattening Yield Curve: Short term rates are rising faster than long-term rates
Steepening Yield Curve: Long-term rates are increasing faster than short-term rates
Point of Inversion: Short-term bonds are yielding more than long-term issues
A normal yield curve has 200 basis points at a 2% spread with the left end starting at the lower left hand corner (2 Year Treasury Rate) and gradually rising to the upper right hand corner (10 Year Treasury Rate). The y-axis reflects rising interest rates while the x-axis represents time duration. (See below)
The slope of the yield curve reflects the inverse relationship between a bond’s yield and price. To explain, when bond prices increase, yields go down, and when bond prices fall, yields increase. These two measurements continually change to keep up with current interest rates since they are traded on an open market.
*Example: A company issues a new bond on the market, Bond A, with a coupon of 3%. Over the next 12 months, interest rates rise and the company decides to issue another bond, Bond B, with a coupon of 3.5%. Since the coupon stays the same, the price of Bond A has to fall in order to attract buyers and generate the same yield as Bond B.
Interest rates continue to be one of the most important indicators of an economy’s performance. Let’s explore specific factors that affect interest rates and the yield curve to gain a better understanding of where the economy is headed today.
Factors Influencing Yield Curve Projections
The “short end of the curve’, or short-term rates, are heavily influenced by future government actions, specifically regarding Federal Reserve policy. When the Fed is expected to raise interest rates, short-term rates will increase. In the same way, when the Fed is expected to lower future interest rates, short-term rates will decrease.
Long term yields (10 year treasury rate) are not only influenced by future Federal Reserve policies but also by anticipated inflation, economic growth, supply-and-demand, and general attitude toward risk. This rate is most often linked with long term loans likes mortgages and business loans and is a critical driver of the U.S. economy.
Each end of the curve will push and pull with market conditions, resulting in various shapes and slopes. For example, the yield curve steepens when long-term rates rise at a faster pace than short term rates, often times an indicator of underperforming long-term bonds compared to short term issues.
An inversion occurs when short term bonds begin yielding more than long-term issues. This phenomenon has predicted forthcoming recessions in the past because it likely marks slowed economic growth, low inflation and future interest rate cuts.
A Look Into the Crystal Ball
Now that we have a foundational understanding of the yield curve and what certain slopes mean, what does the yield curve look like today and how are investors reacting?
There are two opinions circulating among investors today: the yield curve is heading toward an inversion or long-term rates will break out of the stagnant 3% range and increase over time. The more ‘widely accepted’ opinion is the first– the economy is headed toward a potential economic downturn. Take a look at a current snapshot of the yield curve below:
As you can see, the yield curve is essentially compressing or flattening, with the spread hovering only slightly above a quarter of percent. Depending on the day of the week and current market conditions, the curve will fluctuate up and down, but the general direction is downward.
The fear is that the yield curve could invert later in 2018 by looking at historical data. The problem, however, is there is no way to distinguish how long the inversion will last. The current yield spread is continuing to decline, indicating the gap closing between long-term and short-term rates.
Why Short-Term Rates are Rising
A pressing reason why analysts predict a coming inversion is due to financial statements made by the Federal Reserve Open Market Committee. They predict federal fund rates (the rate at which banks pay each other in overnight deposits) to increase over the next couple of years.
Currently, the federal fund rate is hovering around 2% while the 2-year treasury rate is at 2.6%. It’s higher because of the expectation that the federal fund rates will increase from 2% to 3.5% through 2019.
The federal fund rates are increasing because of growing concern over inflation. By raising the discount rates, they are putting the brakes on inflation, and as a result, individuals are incentivized to put their savings in the bank due to higher interest rates banks are paying. The rate banks pay is normally a direct link to short-term rates.
With higher short-term rates, people will focus on saving rather than spending, leading to a decrease in demand in goods, therefore, resulting in economic deflation.
Why the 10 Year Treasury Rate is Struggling to Keep Up
Like we mentioned, the 10-year treasury rate is essentially the main index point for long term loans like mortgages and business loans. It’s a critical driver of the cost of money in the U.S. economy.
This long-term rate has continued to hover around the 3% mark while short term rates continue to rise.
One of the reasons the 10-year treasury rate isn’t moving is because the bond market doesn’t anticipate high inflation in the future. The bond market itself is a much more powerful tool than leading economists could ever predict, so it’s an important factor to consider.
With this rate hovering around 3%, the bond market is anticipating there might be some short term inflation, but it will come back down in the long run to around 3%.
With the combination of federal funds rising and long-term rates staying stagnant, it’s clear why analysts are leaning toward an inversion later this year, but let’s look at the other side of the coin to get a holistic picture into yield curve predictions.
Theory #2: The 10 Year Treasury Rate Will Rise to ~5%
CEO of JP Morgan, Jamie Dimon, is predicting a different outcome than what most analysts are expecting. He believes the 10 year treasury rate will break out of the 3% standstill and rise to nearly 5% over the next couple of years.
This would signal high inflation and significantly increase the cost of borrowing on everything.
*Investor Tip: What impact does an increase in cost of borrowing have on businesses? Both big and small corporations pay more for 15 and 30 year loans since banks can charge more for loans. It often times hinders profitability for businesses and negatively impacts affordable housing.
It’s true the economy is running at a high GDP, but there has not been high wage inflation that would support Dimon’s theory. With both theories circulating, it’s uncertain exactly how the economy is going to turn out, but what is certain is that investors need to be prepared for both outcomes.
How to Prepare Your Investment Portfolio for Economic Change
In the last 5-10 years, markets have appreciated signaling overall market growth. Current asset prices are high with affordable housing on the rise. One sector of the economy that continues to slow down is high-end condominiums and townhouses (in cities like New York and Miami). With these current market conditions, how can investors protect their investments in an age of possible rising interest rates?
Two words: Mitigate Risk.
Real estate has a history of holding value in times of high inflation. When commodity and wage inflation increase at the same time, people are able to afford higher rents– creating a hedge of protection for your investments.
In order to protect yourself agains the coming market change, here are four strategies to mitigate risk in your portfolio:
- Shift your portfolio to alternative assets.
- Reduce leverage and focus on heavy cash flow projects.
- Force appreciation.
- Refinance your property.
If you are only investing in the stock market, now is the time to look at alternative investment sectors to protect your cash flow. Based on historical data, the stock market is looking to perform in the low single digits over the next 10 years. Real estate continues to be a strong alternative option to the stock market with its depreciation advantages, strong cash flow, and value-add opportunities.
Real estate is not your typical heavily-leveraged investment for maximum appreciation. Rather, it revolves around value investing. By reducing your leverage in real estate, you might lose some upside, but you are protected if the economy takes a downturn. It’s simply a hedge of protection. With current yield curve projections, the best investment strategy today would be to reduce leverage, borrow less money, focus on strong cash flow, and focus on assets with upside.
The value of real estate is that you can force appreciation and increase your return regardless of market conditions. The key lies not with retail, but with value-add projects. Increasing forced appreciation looks like making renovations to a home or adding some extra value to a property. It requires more work, but can result in significant cash flow in the long run.
Another option to protect your assets against future market change is to refinance now and lock in good long term rates. If Dimon’s theory is correct and cost of borrowing increases, you can save yourself lots of future interest costs by refinancing now. If the market continues to do well, you can always refinance again in the future. This strategy is key to mitigating risk across your portfolio while rates are still fairly reasonable.
If interest rates increase and the yield curve inverts, every investment sector will be affected in some way; it’s choosing the asset class that will reap strong cash flow and act as a hedge against an economic downturn.
Since real estate proves to be a good option for investors time and time again, let’s take a look at two different ways to invest in real estate.
- Individual Deals
When you invest in individual deals, you have a lot of flexibility and control with your investments. The downside, however, is you need to have the amount of capital needed to invest which is often times a significant amount. Many investors will enter into deals with partners who are able to supply the amount of capital needed.
An alternative option to individual deals is to invest in a fund. Most funds provide a diversified portfolio of assets which offer strong protection against market changes. It’s a completely passive option to invest in real estate. You can think of it as a short term, high-yielding bond secured by real estate.
With a potential economic downturn in the near future, it’s time to secure your investments in order to protect your future wealth. The Tempo Opportunity Fund LLC is a great option for investors looking to passively invest their money for strong returns. To learn more about our fund, visit www.https://tempofunding.com/investors/ or contact us and we would be happy to walk through opportunities.
Thanks for reading,
CEO, TF Management Group LLC
This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.
TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.