By: Dividend Sensei
Recently I’ve been warning my readers about growing risks to the economy. A trade war is my biggest concern, but there are also two other growing risks that threaten to derail our nearly decade long economic expansion and bull market. As part of my method for tracking macroeconomic risks, I’m constantly monitoring important economic reports and indicators that can provide an early warning of trouble ahead. Let’s take a look at two very important reports that are coming this week that could have long lasting ramifications for the economy, corporate profits, and your portfolio.
Federal Reserve Minutes: Thursday July 5th
While the Federal Reserve’s interest rate decision and press conference get most of the attention, the Fed meeting minutes, which get released two weeks later, are arguably more important. That’s because they allow us to get a clearer understanding of what each of the 15 members of the Fed’s Open Market Committee or FOMC, are thinking about the current state of the economy, inflation, and where interest rates need to go. In other words it’s a peak behind the curtain at the rationale behind the Fed’s latest decision. But more importantly it can provide clues for what future interest rate policy might look like.
In this case what I’m especially focused on is what the Fed makes of our rising trade war risks. According to Ben Emons, chief economist and head of credit portfolio management at Intellectus Partners, “The minutes will be important because we’ll get a further idea about what kind of caution is shaping into the Fed’s thinking regarding the effects of the trade war. There is a group that already wants to pause hiking. If the market senses a bigger campaign for that, then traders will lower the probability for a third or fourth hike and that should at least moderate the curve flattening.” What Mr. Emons is referring to isn’t traders in the stock market, but the much larger and more important bond market. While stocks may get most of the attention from the financial media, the bond market sets long-term interest rates for: corporate borrowing, mortgage rates, and government borrowing. In other words, the bond market is what drives the economy, which is the ultimate source of corporate earnings growth that determines dividend growth and stock price movements over medium and long-term.
The most important thing for investors to know is what the 2/10 year Treasury yield curve is doing. This is the difference between 2 year Treasury yields (proxy for short-term interest rates), and 10 year Treasury Yields (proxy for long-term rates). Normally in a healthy economy short-term rates are lower than long-term rates. This is because bond investors most care about inflation, which eats away at their fixed income coupon payments. Normally in the short-term there is little risk that inflation will surprise to the upside, so bond yields are lower. In contrast 10 year bonds require investors to take on more risk, because the future is uncertain and higher inflation in the future could cause them to lose money over a decade long stretch of time (if inflation is higher than yield then real return is negative). You can think of it like this. If the bond market, which is mostly controlled by giant institutions such as pension funds, insurance companies, and sovereign wealth funds, thinks economic growth is going to be strong, then inflation expectations are high. That in turn means that long-term rates should rise to compensate for higher inflation risk with higher yield.
On the other hand if the bond market thinks the economy is likely to be weak, or fall into a recession, then inflation risk is low, and yields fall. That’s also because if the bond market fears a recession is coming then there is a “flight to safety” and greater demand for risk free US Treasuries. When bond prices go up, yields fall. Here’s where the yield curve comes in. In the past 60 years short-term rates have only gone higher than long-term ones (what’s called a yield curve inversion) 10 times. In nine of those times a recession followed within 12 to 18 months. Only in the mid 60’s was there a false positive signal, where economic growth slowed to a crawl, but failed to go negative for two consecutive quarters (definition of a recession).
The yield curve has been falling steadily since trade war fears started rising significantly, and the curve now stands at 0.34%. That’s the lowest level in 11 years and signals the bond market is getting increasingly bearish on the economy, likely due to concerns that higher tariffs will slow the economy. On June 20th, Fed Chairman Jerome Powell was at a European Central Banking Conference and told reporters “Changes in trade policy could cause us to have to question the outlook.” That’s because the Fed is constantly monitoring leading economic indicators and has started hearing from more and more companies that are holding back on planned investments over trade related uncertainties.
The Fed minutes might indicate that the Fed’s trade related concerns are rising, and if that’s true then it might mean less interest rate hikes than are currently planned (six through the end of 2020). The Fed funds rate has an indirect effect on 2 year Treasury yields (which follow the FFR). It has no effect on the 10 year Treasury yield. This ultimately means that if the Fed pulls back on rate hikes the curve should stabilize above the dangerous negative level that would signal a recession is likely by 2020. However, as important as the Fed Minutes are, there is an even more important report coming that you need to pay attention to.