NWP Monthly Digest | September 2024
Last month, U.S. school classrooms started to fill up. It may have been the first time children born in a post-COVID world have set foot in a classroom. They will also witness an all-but-certain cut in rates by the Federal Reserve following their policy meeting on September 17th and 18th.
I was fortunate to experience the bittersweet milestone of sending our oldest child to school on August 21st. Many of you readers know the challenge of watching your child walk into a school for the first time, and for those who have yet to experience it, it's a moment nobody can prepare you for. So much was going through my head—how did he grow up this fast? Is he going to be okay? Time flies, and it's a reminder to savor every minute with your loved ones. After we said our goodbyes, our son’s teacher held his hand as they walked off. As they headed toward the school, he frequently turned around to look back, as he didn’t want us to leave him. It’s heartbreaking to watch; tears fell, but this was the best-case scenario.
We were lucky our son didn’t throw a tantrum, sobbing uncontrollably, while refusing to go into the school. A horrible outcome, but easily within the realm of possibilities. He’s only three and has never been to school before. This was uncharted territory, similar to the Fed cutting rates for the first time in four years. The stock market could throw a tantrum of similar magnitude because it may be too soon to cut rates. If that were to occur, the market would be signaling to the Fed that rates need to stay elevated to prevent runaway inflation—akin to what transpired in the 1970s when a cut by the Fed was followed by inflation above 15% in the 1980s. A policy mistake Powell is cognizant of and would not like to repeat.
A worse outcome that would have destroyed us as parents would be if our son had walked off without a care in the world. Did he want to take this step a long time ago? A similar scenario exists for the Fed: If we witness a market response showing the Fed should have cut rates earlier, that reaction could signify that growth is waning more than previously thought and that a larger cut was needed to prevent financial calamity. The result could be panic in the market and a precipitous sell-off. The latter is a possibility, as the Fed was expected to cut by half a percent at the beginning of August, but now those odds have pulled back significantly. The more likely scenario is a cut of 1/4 of a percent, and the market will determine whether that is enough to maintain an extraordinarily strong economy by historical standards.
As I write this newsletter, the market is charging higher, suggesting the Fed’s action is the best path forward. Yet it would not be a surprise if, like my son, the market occasionally turns around and second-guesses whether the cut was indeed the best path forward.
Why Is the Stock Market Rising?
When the Fed cuts rates, it's generally seen as a positive sign. In the last 18 instances when the Fed cut rates for the first time after a period of rate hikes, the stock market had positive returns over the next 12 months 72% of the time, with an average return of 13 percent. Not bad!
It's been rare for stocks to be down three years later, and the market has never been down five years after the initial rate cut. However, each cycle is unique, and the market’s fate will depend on the circumstances behind the rate cut. Is economic calamity charging ahead like a freight train, in which case the Federal Reserve lacks the muscle to slow it down? Or will the Fed play hero by proactively cutting rates to prevent systemic risks from emerging?
Recession Warning - What Can We Learn From the Yield Curve?
The yield curve can provide us with prescient insight not only into investor expectations about future growth but also into the Fed's policy cycle and perhaps even the business cycle. There are a lot of moving parts to the yield curve, and the way each piece of the Treasury market puzzle is acting can offer valuable insight as to whether we are on the brink of an imminent recession or if a soft landing remains more likely.
General Terminology:
Yield curve - The yield curve is a graph showing the relationship between interest rates of bonds with different maturities. It helps indicate market expectations of future interest rates and economic conditions.
Bull steepener - A bull steepener occurs when short-term interest rates fall faster than long-term rates, causing the yield curve to steepen. It typically reflects expectations of lower economic growth or lower inflation.
The term reflects a generally optimistic view of bond prices (which rise as interest rates fall), particularly at the short end of the yield curve.
Bear steepener - A bear steepener happens when long-term interest rates rise faster than short-term rates, steepening the yield curve. This often indicates expectations of higher inflation or stronger economic growth.
The term reflects a generally negative view of bond prices, as the rising rates would result in falling prices and would hurt bond investors.
For those outside of the financial industry, the terms “Bull” and “Bear” stem from the fact that a bull attacks by thrusting its horns upward, symbolizing rising prices or a positive outlook in the market, and a bear attacks by swiping its paws downward, symbolizing falling prices or a negative outlook in the market.
Background on Interest Rates
Interest rates are the compensation for investors who loan funds to another entity. Without interest rates, everyone would keep their money in a safe place, and bonds, CDs, and other investments wouldn't exist. So, what determines these interest rates? Fixed income is a general term that includes bonds, CDs, and any investment that pays a specific amount to investors—hence the term "fixed income." For short-term fixed-income investments (two years or less), rates are mainly influenced by the actions or perceived actions of the Federal Reserve. For longer-term fixed-income investments (those with maturities between 7 and 100 years), rates are driven by the prospects of the economy and inflation expectations. (For fixed-income investments with a risk of default, there's an additional component to compensate investors for the risk, known as credit risk, but I won't discuss those instruments here since this analysis is limited to instruments backed by the full faith and credit of the U.S. government.)
The Federal Reserve has the power to change the Federal Funds Rate, which is the interest rate at which banks lend to each other on an overnight basis. Any changes in the Federal Funds Rate indirectly affect all short-term interest rates. It's a common misconception that the Fed controls rates with longer maturities, such as mortgage rates, but that's not the case. The Fed is responsible for promoting full employment and stable prices, which also affect long-term bond and mortgage rates. So, while an interest rate hike by the Federal Reserve may seem to increase long-term bond or mortgage rates, it's actually due to the Fed's response to the expected strength in the economy and rising prices. It's important to note that correlation does not necessarily imply causation in this context.
The yield curve illustrates the relationship between short-term interest rates and long-term interest rates and provides insights into the economy. A typical yield curve has lower short-term interest rates and higher long-term interest rates, creating an upward slope. This reflects investor confidence in the economy, as they demand higher compensation for locking in their savings for a longer period. However, there are times when the yield curve inverts, meaning short-term rates become higher than long-term rates. In this scenario, some investors choose to invest in longer-term bonds at lower rates because they anticipate a decline in economic growth and interest rates. This strategy allows them to secure a rate they believe will outperform shorter-term investments over the bond's duration. For instance, investing in a 10-year Treasury bond at 4% may be preferable to a shorter-term investment earning 5%, especially if economic growth and inflation are expected to decrease.
A normal yield curve is upward-sloping, which typically indicates positive economic growth and inflation in most economies. Conversely, a downward-sloping or inverted yield curve suggests an expectation of slowing economic growth and inflation. This is why an inverted yield curve has preceded each of the last eight recessions dating back to the 1950s.
Dynamics of the Yield Curve and the Business Cycle
In the early stages of the business cycle, the Federal Reserve keeps interest rates low to ensure that the economy is stable, which mainly affects the short end of the yield curve. As the economy starts to recover, the long end of the yield curve begins to rise in response to the improving economy and increasing inflation. This phase of the business cycle typically leads to above-average stock market returns, and the yield curve is upward-sloping, with long-term rates higher than short-term rates.
Eventually, the healthy growth manifests into an overheated economy. Almost always, the cause of a broader economic slowdown or financial crisis is excess—excessive spending, excessive speculation, and excessive borrowing, both at the individual and institutional levels. These excesses naturally produce booming economies, unsustainable stock market returns, a rosy employment picture, and above-average inflation. As the Fed becomes concerned about the economy overheating, creating economic and financial bubbles, they feel obliged to hike short-term rates to mitigate the excess. At this point in the business cycle, a bear steepening pattern forms in the yield curve as long-term rates increase due to the booming economy and rising inflation, while short-term rates increase due to the Fed’s actions as they attempt to set the economy on a more sustainable trajectory. And this continues until the economy reaches a tipping point….
The Fed will usually tighten monetary policy (i.e., hike rates) until the economic data demonstrates the economy may not be able to handle additional tightening. It’s not uncommon for cracks to begin forming before the Fed has reached this conclusion. At this stage in the business cycle, short-term rates are elevated after the Fed has hiked rates, but investors have taken note of the economic risks, driving down long-term interest rates. The yield curve eventually becomes inverted once long-term rates have fallen past short-term rates. The yield curve is inverted as the Fed has not yet cut rates and investors do not yet plan on them doing so, while long-term interest rates have fallen. For these reasons, an inverted yield curve is seen as an imminent recession threat since it has preceded every recession going back to the 1950s by an average of 12 to 18 months. Most investors know this…
A strong economy can endure tighter monetary policy, so the Fed's actions may not immediately derail growth, leaving the yield curve inverted for a sustained period. However, this dynamic does highlight economic fragility, leaving the economy vulnerable to a financial crisis. If the Fed acts quickly and addresses these risks before they metastasize, they may be able to avert a recession through aggressive policy. We witnessed these actions last year when the Fed and the Federal Deposit Insurance Corp. managed to stop last year’s mini-banking crisis from turning into a credit crunch by constructing an emergency lending facility and guaranteeing all deposits, at SVB and Signature Bank, respectively. However, this game of monetary Whac-a-Mole is not sustainable, and eventually, the Fed misses or faces an insurmountable threat, and the descent of the economic train is inevitable.
At this point, the Fed knows they must act and reduce short-term rates to stave off bigger issues. The confluence of falling short-term rates and long-term rates provides a clear bull steepening trend in the yield curve. As the market recognizes the need to cut rates, short-term rates fall past long-term rates, and the yield curve un-inverts or turns positive. Finally, long-term rates are above short-term rates. Most investors do not know this is when they should worry…
Canary in the Coal Mine
This transition from a negative to a positive yield curve is a clear demonstration that investors recognize the risks are significant enough for the Fed to cut short-term rates below long-term rates. A development like this would not occur outside of a recessionary environment, and for that reason, it is the uninversion of the curve that provides a timely warning signal to investors. In other words, the inverted yield curve reveals the fragility of the economy, and the move from inverted to uninverted reflects the acknowledgment by the Fed and investors of the severity of the risks that may lie ahead.
Since the Federal Funds Rate is the key tool for the Fed to influence interest rates, and this is an overnight rate between banks, the Fed only has the ability to control rates with the shortest maturities. Therefore, the rate of the 3-month Treasury Bill is a good proxy to measure the actions the Fed is currently taking. The interest rate of the 2-year Treasury Bond is a good proxy for the actions investors expect the Fed to take. Though perceived actions by the Fed may influence the 2-year rate, the Fed cannot directly influence rates with longer maturities. For that reason, most economists use the spread between the 10-year Treasury Bond and the 2-year Treasury Bond to gauge inversions and reversions of the yield curve. The spread between the 10-year Treasury and 2-year Treasury will be negative when the yield curve is inverted, as the 2-year rate is higher than the 10-year rate. This makes sense because the 10-year rate will fall when the economy is vulnerable, and the 2-year rate will stay elevated when investors do not expect a cut from the Fed. Using the 10-year rate and 2-year rate, the spread can turn positive before the Fed cuts rates past the 10-year rates because the 2-year rates are based on the expected actions from the Fed. However, the interest rate of the 3-month Treasury Bill measures the actions the Fed is taking and serves as an important confirming signal to investors.
The spread between the 10-year and the 2-year Treasury rates turning positive is a clear warning signal. But when the spread between the 10-year and the 3-month Treasury rates turns positive, there’s a greater likelihood the stock market could be on the brink of peaking into economic weakness.
Today’s Yield Curve
“History never repeats itself, but it does often rhyme.” Mark Twain
The yield curve has been inverted for almost two years as perceived plans by the Fed have stayed well ahead of the fundamental factors driving the long end of the yield curve. Earlier this year, the bond market experienced a bullish development as interest rates at the long end started to fall, signaling that investors anticipated lower inflation and slower economic growth—a clear demonstration of a bull steepening trend in the yield curve.
“We do not seek or welcome further cooling in labor market conditions. The time has come for policy to adjust.” — Fed Chairman Jerome Powell on August 23rd, 2024.
Yeah, with only the long end of the yield curve following, without a corresponding follow-through by the short end of the yield curve, as investors continue to push out the date when the Fed will eventually cut rates, the yield curve remains deeply inverted. It wasn’t until recently that the short end of the curve also began to lose support and fall rapidly as a result of waning economic momentum, providing the go-ahead for the Fed to cut rates in September. Many investors wish they had done so in July. We find ourselves at the crossroads where the yield curve was a stone's throw away from turning positive at the beginning of this week, but as I’m writing, the 10-year minus the 2-year Treasury yield has just turned positive! Now, let’s wait and see when the 10-year minus the 3-month Treasury yield turns positive before we lose any sleep. This occurred about a month after the 10-year minus the 2-year Treasury rate turned back positive in the last two recessions (December 29, 2000, and June 6, 2007). Market pricing implies this may not occur until the spring of next year. At this time, recall the 2-year yield measures anticipated actions by the Fed, while the 3-month yield measures what the Fed is doing. Therefore, this provides another supporting signal that the unsustainable returns we’ve witnessed over the past few years are coming to an end.
While the financial media has heralded an interest rate cut by the Federal Reserve as a positive, investors would be wise to remain cautious in this environment. Against the backdrop of bull steepening trends across the yield curve, in conjunction with the yield curve turning positive in light of the Fed's actions this month, investors would be wise not to dismiss these developments and should heed the Fed's actions.
Though many coincidental indicators—or those economic indicators that tend to confirm the state of the economy—are still flashing green, several leading indicators, with near-stalwart clairvoyance through past cycles, are flashing orange, if not red: the leading economic index, manufacturing service, and unemployment trends.
The economist Claudia Sahm published what’s known as the Sahm Rule. This signal is triggered when the three-month moving average of the unemployment rate increases by 1/2 of a percent within a 12-month period—another measure that has a strong correlation with past recessions. But even Claudia Sahm is discounting the signal from her indicator, stating that this was triggered by a flood of new entrants into the labor force and that the Sahm Rule could be giving a false signal for this cycle. It’s interesting to hear those arguments because new entrants in the labor force increase the unemployment rate in almost every recession. But she’s not alone; the consensus among economists is that there is a low probability of a recession over the next 12 months—less than 25% on average. Will those economists be right, and will this time be different? We’ll see, but I am skeptical we can dodge a slight recession without aggressive fiscal or monetary policy. And in this political environment, it’s tough to imagine we’ll see either. I’m not telling you readers to run for the fences, as even if we encounter a recession, it’s likely to be mild. Some investors are still likely to be best served by taking a long view while filtering out the noise.
While the data remains mixed, at Noble Wealth, once the developments above are paired with an uninversion of the 10-year and 3-month yield curve, it signifies it’s time to increase vigilance.
Noble Pro Tip of the Month
Beneficiary RMD Rules
The IRS finally released long-awaited rules clarifying when RMDs must be taken from inherited IRAs. Specifically, non-spouses who inherit an IRA account after the original owner had already begun taking required minimum distributions must continue to take RMDs on an annual schedule. Once the tap starts flowing, you can't turn it off. This new rule applies to those who inherit traditional IRAs and 401(k)s after 2019. Previously, adult children and other heirs could stretch their distributions over their lifetimes, but Congress felt this was too much of a tax break. Now, most non-spouse beneficiaries must accelerate that withdrawal timeline to just 10 years.
This is a significant change that shifts much of the tax burden to those inheriting pre-tax retirement accounts. For those with significant balances in their IRAs and 401(k)s and goals of not placing too much of a tax burden on those inheriting these balances, it may be wise to map out a plan to accelerate the tax burden during your lifetime.
Have You Digitized Your Estate Plan?
Everyone has a Will, but how many of you have taken the time to provide instructions to your loved ones to access all of the files (paper and digital) they will need after you pass? Many people do not realize the burden facing their survivors in the form of countless digital files, online accounts, subscriptions, etc. Having an organized guide for your survivors, similar to a treasure map, could be invaluable, and they will surely appreciate your efforts.
Those with a Wall Street Journal subscription can read the article by clicking on this link, and those without can focus on the key takeaways:
Label your files as either "relevant," "memorabilia," or "Delete upon Death" (capital D, lowercase o, capital D).
The relevant files include anything of practical use to those who will need it. Documents or emails that you want your friends and family to see would fall into this category, perhaps even instructions to continue some of your work and pick up where you left off on some items that may be important to you, maybe a garden or project you've been working on. This could also include a list of all the websites and emails you've used over the years, including the username and password for accounts that require two-factor authentication. Make sure there's an option to access those accounts after you are no longer around.
Memorabilia includes family photos and personal documents that you want children or grandchildren to read in 30 years, maybe letters from your family—all keepsakes.
Finally, the DoD label is for things that are irrelevant to anyone else and for those that you don't want anyone to see, and this folder is the most important one. Special care needs to be taken with digital files.
Leave a guide and maybe a farewell. Make sure people know where to find it, and this will include instructions. In this guide, you may mention instructions on how to access some of the files, including your social media files. Consider leaving an AI alter ego.
After rapid advances in generative AI, it might be possible to have a digital alter ego that makes it easy for children to ask about what happened on a certain date and possibly interact with you. Digitize your physical memories.
Social Security Recipients
Projections for the cost of living adjustment (COLA) to Social Security payments indicate a 2.6% increase, which is less than the 3% forecast. The COLA adjustment is designed to increase income for retirees at about the same pace as their living expenses. However, these are average numbers and are based on a basket of goods that may not reflect your current spending needs. If Social Security makes up a significant chunk of your retirement income and your expenses are increasing at a faster pace than your Social Security payments, it's time to reevaluate your retirement plan and find assets in your portfolio to hedge against inflation risks. Not sure where to start? We're happy to help.
What We're Reading
Decisions about Decisions: Practical Reason in Ordinary Life | Cass R. Sunstein
It's possible that you or someone you know has been misdiagnosed or mistreated by a doctor, as doctors are not immune to unconscious biases and the influence of decision-making. For example, they may be more inclined to test for certain conditions if they have recently treated other patients with those conditions, instead of fully considering relevant studies. The book "Decisions About Decisions" explores how emotions can affect judgment in decision-making, and how information plays a complex role in the process. Beliefs often stem from a decision to believe, influenced by social dynamics, but using tools can make these decisions less burdensome. Considering the upcoming election season, it's important to assess whether the information and decisions you encounter are rational, as people tend to believe what they want to believe, as noted by the author.
