As the yield curve flattens, fears of a recession rise. But those fears will only come to life if the curve actually inverts. Will it, and what does that mean for the next 12-24 months?

Stocks were mixed yesterday with tech and energy stocks higher while most other sectors fell. There will be lots of news over the next 48 hours. Most if it, however, most be impactful on markets. The one exception is the two-day FOMC meeting that concludes with an interest rate announcement at 2pm this afternoon followed by a press conference by Fed Chair Jerome Powell at 2:30. Market watchers will want to see if Mr. Powell gives any clarity for the future path of interest rates.

I often caution that markets can be very volatile on the afternoons after an FOMC meeting. That could happen today as well although today’s actions have been well telegraphed. A quarter point rate increase is a virtual certainty and Mr. Powell will probably indicate that one more increase is coming in December followed by 2-3 more next year. With the 2-10 Treasury interest rate spread now down to 13 basis points and likely to continue to close in the weeks and months ahead, traders will be watching for market reactions to every word Mr. Powell says.

There is a high correlation between an inverted yield curve, one in which the two-year yield exceeds the 10-year yield, and an ensuing recession. Since 1970, the yield curve has inverted six times. The average time between the inversion of the yield curve and the start of the subsequent recession was about 15 months. The average time between the inversion and a stock market peak was 10 months. But averages don’t tell the whole story. Three of the six times, markets peaked within two months of the inversion while in the other three cases, it took 17-20 months before the market peaked. It is important to note, however, that yield curves can flatten without inverting. When that occurs, recessions and bear markets rarely happen. Thus, we shouldn’t put the cart before the horse. In 2014, the 2-10 spread was close to 260 basis points. It has been falling since then. But as the spread has been falling, stocks have risen by more than 50% and economic growth has accelerated without any sign of serious inflationary pressures.

The message behind a flattening yield curve is that the Fed is getting close to established a neutral Federal Funds rate without impeding the ability of the economy to continue to grow at a pace that will not force overheating and significant rising inflationary pressures. The message of an inverted yield curve can actually be one of two. Either the Fed is moving interest rates up too far in an economy where there is little or no inflation, stifling growth unnecessarily. With housing and auto sales showing signs of rolling over and the prospect that tariffs could be a headwind to growth, this is a possible outcome. The alternative message of an inverted curve is that robust growth continues but it also ignites inflation that can’t be controlled without further rises in interest rates and an overt attempt by the Fed to slow the economy.

Of course, we don’t know which to believe and, as the curve continues to flatten, fears that it may invert rise. Obviously, there are no such fears when the spread is 1-2 percentage points. It becomes palpable when the spread gets below 25 basis points.

So far, there are just hints of rising inflation. They show up in wages, education tuition and some parts of the health care system. But we have been living with rising tuitions for many years and there are clear signs healthcare inflation is receding. Home prices are still rising but at a slower pace. Low unemployment suggests wage pressures can continue but rising productivity is offsetting most, if not all, of that pressure. Tariffs will add a bit to inflation as will rising oil prices. But these are temporary and not systemic factors.

Taking the opposite tact that growth could get too hot igniting inflationary pressures, that too is a tough argument to swallow. The benefits of the corporate tax cuts are likely to be felt most this year. Federal spending cannot expand at the same pace as last year with exploding the deficit. Debt service costs will become a real concern but not when 10-year Treasuries are barely above 3%.

Perhaps the most likely scenario is that the curve does invert slightly by mid-2019 setting up a market correction either later in 2019 or in 2020. I should note that once a yield curve inverts, it offers few hints of the severity of any subsequent market downturn. Economically, imbalances looking forward do not look anywhere near what we witnessed in the Great Recession. 2

Stock markets are often strongest near the end of bull markets. We really have not seen the euphoric stage of this bull market over the past 9 years. There are few reasons, at the moment to seek out bonds or cash. Market tops also tend to roll over. That process can take many months with at least one attempt to break through to new highs. Today with stock markets at all-time highs and going still higher, it is far too early to get overly defensive. But, at the same time, it is the wrong time to become euphoric. Market leaders have gone through a mild pause in recent months but they show few signs of rolling over in a way that would be predictive of a bear market. That suggests, despite the narrowing of the bond spread, that it is too early to become defensive in a serious way.

Perhaps the best advice is the advice I give most often. Stay true to your asset allocation. If your stocks have risen a lot, take some money of the table and reallocate. If you are really worried, despite my advice to stay long, consider shifting into some more defensive names. They won’t do as well as the market if there is a final euphoric leg, but they won’t hurt you if stocks fall sooner than expected.

Stocks are long term assets and, over many years, they overcome the damage of bear markets and recessions. That is why staying true to your asset allocation works so well. You end up selling a bit at the top and buying at the bottom. There is nothing on the economic front to suggest a long term cyclical downturn. A mid-course correction, should it occur, might not be so painful this time around. Stay calm, stay disciplined and pay attention to value.

Today, Serena Williams is 37. Olivia Newton-John is 70.

James M. Meyer, CFA 610-260-2220

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