Fall Update: Tariffs and The Yield Curve

This year has not been so good for financial markets with the best performing asset class being large cap U.S. equities which are essentially flat for the year (as of December 6th). U.S. small caps are down about 5% and International stocks are down over 10%. With rising interest rates, bonds have had a tough year as well with the benchmark bond index down 2-3% for the year. These sorts of years are going to happen from time to time. When they do, we take a step back and verify that our clients are still on track. Focusing on our long-term investment strategy helps our clients stick to their plan when the tough market cycles come.

Trade with China

You almost certainly have seen the headlines about tariffs and trade wars with China. This has been a topic of conversation all year and it doesn’t seem that it’s going to go away quickly (not as long as 45 keeps tweeting!). If the U.S. implements the proposed 25% tariffs on Chinese goods early next year it will be a tax of over $100 billion that will be reflected in higher prices on goods imported from China. That works out to about 1% of total consumer spending or about $300 per person per year in the U.S. Not the worst tax ever, but still not good for the economy and certainly not likely to strengthen our economy or our diplomatic relationships.

What is a Yield Curve?

You might have seen another common headline about the flattening and now partially inverted yield curve. Plenty of people read that and don’t even know what a “yield curve” is much less why it matters. I’ll try to explain as succinctly as possible.

There are various factors that impact interest rates for loans. One important aspect of a loan is the time until it matures. The rate you receive for a CD is generally higher if the holding period is longer. Same concept applies for mortgages, a 30-year mortgage generally has a higher rate than a 15-year mortgage.

Now take this concept and apply it to the U.S. government. The yield curve is a visual representation of this concept: a plot of what the U.S. government pays in interest for various time horizons (1 month, 1 year, 10 years, etc.) Below is the yield curve on December 6, 2018 as well as one year prior on December 6, 2017. (Data from www.treasury.gov).

If you look very closely you can see that the 5-year data point has dropped slightly below the 3-year data point on the blue line (circled in red). This means that the government is paying more interest for the shorter-term loan. A truly inverted yield curve is downward sloping from left to right. We are just now seeing the very first little bit of inversion. A more complete inversion of the yield curve typically happens about a year before a recession, so it is very early days for this indicator to forecast anything, although it does point to a slowing U.S. economy. What is the likely outcome from this? The Federal Reserve raises short-term interest rates (far left in the above chart) in order to curb inflation and therefore slow the economy down. They are watching the yield curve, too, and they will likely stop raising short-term interest rates sooner than previously expected. It wouldn’t surprise me if the expected interest rate hike later this month is the last one this cycle. If they keep raising short-term interest rates, then the yield curve will almost certainly invert and that means they are pushing too hard on the brakes and we can expect a recession to follow.

What do we do about this potential slow down? For current clients, not a lot right now. We have already positioned client accounts somewhat defensively and are waiting to see notably lower prices. When we do, we will advise folks to get more aggressive by buying equities at lower prices. To get even more defensive would require seeing further signs of economic weakness without a simultaneous drop in equity prices. For those of you not currently clients, if all of this is making you worried you aren’t prepared or are taking too much risk with your investments, we’d love to talk with you about your situation!

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Jason Draut, CFP®
2081 Center St
Berkeley, CA 94704
Chris Sheehy, CFP®
331 Soquel Ave #212
Santa Cruz, CA 95062
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