The Flattening Yield Curve and
a Cautionary Pension Tale
By: Kevin Dombrowski
As of 6/30/18
Past performance is not an indication, prediction or guarantee of future results.
Weekly Update
Stocks were up this week as global trade concerns were momentarily eased with President Trump’s announcement that the US and EU would work collaboratively to decrease tariffs and avoid a trade war. Analysts especially liked this announcement as they believe a similar approach may be made by the Trump administration with Japan, Mexico, and Canada. On Friday, we learned that the economy grew by a whopping 4.1% in the second quarter of 2018, marking the fastest economic expansion in nearly four years.

The S&P 500 had a very strong week across the board. One sore spot was Facebook, the fifth largest US company by market capitalization, which plunged nearly 20% on Thursday after it announced publicly that growth expectations were slowing. Just how big was this drop? The biggest-ever-one-day drop for a US-listed company – losing an eye watering $119.1 billion.

Lastly, there has been a lot of anxiety lately about global oil supply, swinging prices in both directions. US crude prices hit their highest level since 2014 in late June, but have fallen 6.5% this month as global supply appears to be increasing. Still, oil is up 45% in the past year.

Why a Flattening Yield Curve Matters

From a Lender’s perspective, due to inflation, a dollar today is worth more than a dollar tomorrow.  This is one of the main reasons a lender charges higher interest rates for longer term loans and lower interest rates for shorter term loans. As a result, the yield curve typically increases the longer the loan term. This is what is referred to as a normal, or upward sloping yield curve.

From a Borrower’s perspective, an individual is incentivized to borrow as much money for as long as possible at the lowest interest rate possible. If rates are extremely low, borrowers tend to borrow more and for longer, usually giving the economy a boost. 

From an Investor’s perspective, the steeper the yield curve, the healthier the economy, on average. The flatter the yield curve, the more cause for concern given the borrower’s doubt about the near future. If there is a lack of demand for short term bonds, pushing up interest levels more in line with longer term rates, it is often a sign of economic uncertainty. 

Today we see that the yield curve has been flattening especially in comparison to the last few years:
If current market trends remain the same and the Fed continues to raise rates, we may see a flat (if not inverted) yield curve in the next 12 months. 

When the yield curve is flat , there is virtually no incentive to lend money over longer terms, creating tightened credit markets. This may result in individual borrowers not receiving loans because of tightening credit standards. In the instance a borrower has solid credit and can receive lending, there is little incentive for them to borrow for shorter terms, given they can borrow for longer terms and pay the same rate.

When the yield curve inverts (short term interest rates are higher than long term rates), the rational borrower slows or stops taking loans. More often, the most desperate borrowers (lowest credit quality) take out loans, hurting the lender and the economy with higher default rates. 

As this happens, many rational investors save more and invest less. Since approximately 2/3 of the US economy is consumer spending, economic growth slows down, eventually creating a risk of a recession. In the chart below which demonstrates the relationship between the yield curve and recessions, you can see that historically within a couple years of the yield curve inverting (yellow), a recession ensued.  
There is still a lot that can happen before we have an inverted yield curve. However, this is a very important economic indicator to keep your eye on. Will the next inverted yield curve lead to different results? Only time will tell.

If it sounds too good to be true… it probably is!
The Wall Street Journal published an interesting article on Future Income Payments, a company that purchased individual’s pensions and restructured them as private products. These were a complicated high-commission product that were sold to clients of many financial advisors and brokers. In the end, Future Income Payments was shut down, investors were swindled out of nearly $100 million dollars by many estimates, and the founder (who had previously been convicted of a felony) has “no comment” as he is named in lawsuits across the country.

This cautionary tale reminds us that when financial products seem to be too good to be true – proceed with extraordinary caution, or perhaps better yet - steer clear. While mistakes and poor choices are inevitable in life and business, this is a great reminder to appropriately vet your financial professional to ensure that he or she has the sophistication and knowledge to invest your assets in products that he or she fully understands.
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