It’s not just the rush of springtime – investments have been surging ahead since the new year opened. Account values reach new levels and all-time highs. Like a game of “snakes” that also has “ladders”, downturns of 2011, 2015, 2018 are compensated with outsized results as we remain true to “aligning wealth with life.” The pay-off is an abundance for your lifestyle, comfort, and personal wellbeing through all the years ahead.
So remember, when your eyes are on a luminescent screen (whether 4” or 60”) and you’re hearing reports of carnage in stock markets, we’ve already taken steps to reduce the impact. And notice how no such reports mark the daily ascent back up the ladder to new levels. Media push fear all the time because it lifts advertising revenues – and fear-based programs lock onto our internal senses to flee danger. Emotions rise three-times more strongly to bad news than good news … and comparably as shown in a great many studies, average investors earn little more than inflation while focused investors follow guidance to increasing wealth and security.
Before turning to our main question today here are two excellent articles you may enjoy and find helpful:
- Some in the U.S. are forecasting Canadian banking shares could drop 20%. Here is a great summary as to why they are wrong: Shorting-canadian-banks-makes-no-sense. As a result, international opinion is currently weighing down our banking index but in a while that will turn upward to their loss and our gain.
- One in five retirees, age 71 to 75 have chosen to continue working. Harvard University has published a friendly study on the benefits and some cautions of working beyond normal retirement age. In the right situation there’s a boost to physical wellbeing, mental acuity, social engagement, and more. It cautions against risks of physical injury and stress, so it pays to carefully select your retirement career. Harvard.edu_working-later-in-life
Question for this month:
I’m always grateful as clients and friends ask questions we can explore in this letter. Today’s focus could fill a text-book so we’re only going to scratch the surface. In a minute or two you’ll have a basic idea of what the Yield Curve means, how it may act as a warning of future danger, and when it would impact our investment decisions.
Hearing the news recently you could innocently think interest rates were warning of an imminent collapse in the stock market. That would definitely be an overstatement at this time. Yet there are insights even today. For example do you know anyone worrying about mortgage rates? Has anyone been anxious about report that an inverted yield curve will destroy the stock market? … Let’s have a look.
What is a “yield curve”?
— SAMPLE OF THE 2017 RATE CURVE IN CANADA —
This can be pictured as a graph showing short-term to long-term interest rates. Typically short-term rates range from the overnight rate to 365 days, and these are typically quite low. Two- to five-year interest rates are higher. Borrowing for 7, 10, or 30+ years will cause even higher rates. The resulting picture is often an upward sloping graph.
Not long ago for example as 2015 opened, 2-year rates were near 0.7%, 10-year rates were 2%, 30-year rates were near 2.6%. Plotting that on a graph reveals an upward curve. Mortgage rates then began at 2.8% for shorter terms and rising to 4% for longer-term. This is a positive or upward yield-curve: short-term contracts priced less, long term borrowing priced higher.
Negative yield can be illustrated as year-2000 opened. Five- and ten-year rates were near 6.7% but 30-year bonds were lower at 5.5%. Yields then were inverted. The curve went downward. That also forecast the collapse of technology stocks in year 2000.
The curve is not a perfect indicator. It can invert and then turn positive. It has given false-positives, meaning stock markets failed to collapse despite the warning. And even when the alarm is true, damage to investment markets may not take place for another twelve to eighteen months or more, a period that often includes some of the strongest returns of an entire investment cycle. It seldom suggests which types, sectors, or geographies would be hurt or spared. Moreover at historically low interest rates like today it is questioned whether the curve has any forecasting ability at all.
Where is it at today?
Interest rates today are flatter than usual. There is a slight inversion between 2-year and 5-year rates. Recent Canadian rates:
- 2 year government bonds at 1.49%
- 5 year government bonds at 1.45% (inverted)
- 10 year government bonds at 1.55%
- 30 year government bonds at 1.85%
Is that enough to actually call it an inversion? Not in any meaningful way, no! The truth is, we have persistently low interest rates reflecting tame inflation and modest productivity. Central banks favour low rates (and in some countries even zero or negative rates) eager to stimulate growth.
Can a yield curve forecast recession?
If inflation were rising dangerously, central banks would raise short-term rates seeking to reduce inflationary damage. If markets then expected a slowing economy, longer-term bonds could fall. In this manner, central bank action would dampen inflation while markets forecast poor times ahead. The resulting inversion of 10-year over 2-year rates, if continued for at least three months, could warn of recession in the following year or two. 
That’s not where we are today. Inflation is modest. The economy is inching forward. Central banks are purposely adding fuel with low rates. At this point, the curve can toggle up or down – and that’s exactly what they seem to be doing – and it mainly stems from phenomenally low rates across all time horizons.
What else could this mean?
It could mean that while people focus on reducing debt (always a good plan) there is no indication of concern for mortgage rates over the coming year.
It also means that governments are trying to finesse an economic “safe landing” followed by expansion over the years ahead. If they miss and recession does arise, it may be shallow and brief. Any deeper recession (negative growth for two or more quarters) would be awkward as there’s little flexibility to drop rates and stimulate growth. So they would restart quantitative easing to pump money into the economy. Federal debt would then rise. This is a particular risk in the U.S. because their president has held the tap open wide even in good times, pre-spending what would have been a reserve for downturns.
— Picture should be clear — if needed I can resend to you directly.
It’s true, we’re in the later stages of one of the longest bull markets of history. Like Brexit, this stage of the cycle can extend seemingly forever. Yet this “bull” was born in the global meltdown of 2008, a once-in-200-years event from which much of the world is still eking out a prolonged recovery. Europe certainly is; Canada too, and many areas of the U.S. economy. But late-stage doesn’t mean it’s time to close the curtains, fold up the seats and bid farewell. The most lucrative periods of investing include not only early-recovery but also late-cycle periods.
Summary for today.
Bond markets and the yield curve are a deeper subject than we can satisfy here. Whenever you hear in the news what could trigger “fear” or “abandon ship” take a moment to consider if it’s only serving media advertising revenues. If so, it may have no relevance at all to your specific investment portfolio.
A final few thoughts on what we’ve said about “late-stage”. Economies naturally expand and contract: like the aging process, it flows from early, middle, to late-cycle. Unlike aging, things can shift from late-cycle back into middle-stage expansion. Client portfolios also have significant foreign content so may include Europe which has already been recessionary as well as Emerging and Far East economies which are much earlier in their cycle (indeed they now generate over half of global output and three-quarters of global growth). To the degree we’ve globalized our investments, we could say our assets are positioned in “different time-zones.” What I mean is, we invest in early-cycle companies and economies, as well as those in mid-cycle and later-cycle. Our portfolio managers also focus for rising yield, sustained growth, and overall security, through each of these stages.
Stay tuned. If anything changes in your personal circumstances – health or work, personal or family, opportunities or mishaps – reach me and we’ll get you through. Your Certified Life and Financial Plan is where everything connects: life itself, and the wealth to reach your goals.
Freely share this letter whenever it can help a neighbour or friend, and ease the concerns of someone you know. Introduce us — we love to help.
Yours in Financial Security for LIFE!
Brian Weatherdon, MA, CFP, CLU, CPCA. 905-637-3500
627 Guelph Line, Burlington, Ont. L7R 3M7. 1-877-937-3500
Brian@SovereignWealth.ca
Author: A Lifetime Of Wealth — And How Not To Lose It (2013). Protecting Life, Loved Ones, and Future Dreams (2013). Your Business, Your Retirement: Halton Retirement Study (2015).
** This monthly letter touches on key strategies in Canadian and global investing and financial planning. This letter is not an offer to sell any kind of security, insurance, or program. Historical returns and risk measures are not a valid guide to future performance. Returns are from publicly available sources and research from a variety of firms including but not limited to GLC, RBC, CIBC, Mackenzie, Franklin Templeton. Opinions reflected in this letter belong solely to the author and no other body is responsible for the content expressed here. We value opportunity to consult alongside your legal and accounting firms to advance your financial security and unique goals. We are grateful always to receive your comments and questions.