What Are Your “Rules of the Road?”

Jill and I are in the thick of the teenager years. While it is hard to believe our oldest, Maeve, will be leaving for college next year, the Cutter household still has two sixteen-year-old twins left to get through these high school years.

So, teaching the “Rules of the Road” to a teenager who is learning to drive can be very interesting…and daunting. There’s certainly a lot to cover.

Take, for example, the yield sign and the conversation, or as my kids call it “speaking forcefully”, I had with my kid who was driving as we approached the Otis Rotary at Mach 4 speed.

‘“Yield” means to let other drivers go first! A yield sign assigns the right-of-way to traffic in certain intersections. For Heaven’s sake, if you see a yield sign ahead, be prepared to let other drivers crossing your road take the right-of-way. You must exercise CAUTION!!”

As I was reaching for my blood pressure medicine, I got thinking.

You see, yield curves, and more specifically inverted yield curves, have been getting a lot of air time in the news recently. So, this week, I thought we would use our time together to break down some of these concepts and help you understand how it may relate to your financial rules of the road.

First of all, let’s define a yield curve.

A yield curve is a line on a graph that plots the interest rates of bonds that have equal credit quality but mature on different dates. The X-axis (or horizontal axis) is the length of time to maturity. The Y (vertical) axis is the interest rate. A yield curve shows the investor the yield, or total profit, they may expect if they lend their money for a given period. As a result, a yield curve can be helpful in measuring risk.

Ok, I know that sounds very technical, but stick with me here.

The specific Yield Curve that is receiving the most press at the moment is the U.S. Treasury Yield Curve. In this yield curve, the U.S. Treasury Department compares the yields of short-term and long-term Treasury securities. These securities include treasury bills (T-bills), where maturity is measured in days or weeks; treasury notes (T-notes), which have terms from 2 to 10 years; and Treasury bonds (T-bonds), which are issued in 20 or 30-year terms.

Short-term interest rates are linked to the federal funds rate, which is determined by the Federal Reserve. But the market determines long-term interest rates. So, the progress of the yield curve over time shows where investors think the economy is headed. A desirable yield curve should increase over time.

Typically, longer-term investments offer a larger yield than shorter-term investments. After all, investors generally anticipate more compensation for accepting greater risk over time, right? So, the yield on long-term securities should be greater than the yield on short-term securities.

Hmmm . . . What if it is not?

What if the yield curve decreases over time? When that happens, shorter-term rates are higher than longer-term rates. This is known as an inverted yield curve. And this, folks, is what’s been getting all the press lately.

In some ways, it doesn’t make much sense. Why would long-term investors settle for lower returns than short-term investors?

Generally speaking, that’s because the bond markets expect short-term rates to fall. Remember what we discussed earlier, short-term rates are linked to the federal funds rate, which is determined by the Federal Reserve. So, it’s a pretty good bet that the Fed may lower interest rates to help continue to stimulate the economy and stave off possible deflation.

Some economic experts and market analysts believe an inverted yield curve is a possible harbinger of a recession because, historically, inverted yield curves have appeared before significant slowdowns and recessions. In fact, a 2008 paper published by Glenn Rudebusch and John Williams of the Federal Reserve Bank of San Francisco outlined this. Rudebusch and Williams tracked yield curve inversions that happened in 1989, 2000, and 2006, correlating them to recessions in 1990, 2001, and 2008. Other economists have seen similar trends over time.

In fact, in December and again in March the yield curve briefly inverted, at least when comparing two specific Treasury securities. It was the first time it’s happened since the 07-08 recession. In December, the spread between two-year and five-year T-notes went briefly negative. In March, that yield curve inversion occurred again when the yield for ten-year T-notes fell below the yield for the three-month T-Bill.

We had some warning that it would happen – some pundits and economic experts had been signaling that these events were coming for weeks ahead of time. But still, the March event especially made the news. And thus, it’s generated a lot of excitement, as well as a brief frenzy of activity on Wall Street.

But it’s important to provide some context: this inversion is only a few points on a graph. This does not mean another recession or economic calamity is right around the corner or that we’re in one now. An inverted yield curve can happen even when the economy is growing, as ours continues to do. Even after the March incident, yield curves have been moving upward again. What’s more, the experts who think that inverted yield curves are indicators of recessions recognize that inversions can happen quite some time before recessions do.

However, because inverted yield curves can and have predicted economic troubles farther down the road, they’re worth your attention . . . they are worth a moment of pause. Economic indicators like this can indicate future market volatility and may warrant caution.

Folks, this is why forward-thinking strategies that use risk-mitigation triggers to account for changes in market momentum can help to preserve and protect your investments when things get turbulent. Risk mitigation triggers are based on quantitative data, such as the inverted yield curve, to help achieve the highest probability of financial success. Now would be a very good time to pause and show caution to ensure you are employing risk mitigation triggers into your retirement system.

And, if you’re not . . . why.

The recent yield curve inversion was an interesting data point that certainly garnered enough news headlines to elicit a lot of curiosity from folks. It’s certainly something to keep an eye on and worthy of a pause.

It’s also worth noting that we ended 2018 with one of the worst quarters in years. These and other occasional warnings should serve as a reminder to all investors to look carefully at their portfolios to see where significant volatility may be mitigated. Managing downside risk helps to put every investor in a better position for financial success.

Folks, what are your financial rules of the road?

Be vigilant and stay alert, because you deserve more.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at jeff@cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.

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