My house has recently been taken over by another musical Disney flick. Encanto is a tale about a magical family that struggles with the pressures of life. One of the characters, Uncle Bruno, has a scary habit of making predictions that tend to come true. Bruno disappeared one day and no one dares talk about him.
Boring bonds aren’t as fun as Bruno, but both are a tremendous predictive power. The predictive power of the bond market lies within the differences between various interest rates. That is why loans of different duration, or lengths, have different interest rates; generally, the longer the loan, the higher the interest rate. Currently, there is little difference between longer-term bonds versus short-term bonds, a “flat” yield curve. If short-term bonds start paying more than longer-term bonds the yield curve becomes “inverted”. This inversion has been a great predictor that a recession is somewhere on the horizon – three months to eighteen months ahead. Importantly the longer the yield curve stays inverted, the stronger the signal.
Well, what should we do when the yield curve turns negative? Even with an oncoming recession, stocks have actually fared quite well in the short term and long term. There is some initial bumpiness, especially in the short term, but historically the market regains its footing in short order. Data from the WSJ shows that markets are usually higher from three months to three years after an inversion. The yield curve is one of many indicators that we use to steer your portfolios. There are numerous other indicators around manufacturing activity, employment, and housing that still point to a robust economy.
Where does this decline in bonds leave us? Watching both bonds and stocks get hit has been particularly painful this first quarter. Bonds aren’t buffering the volatility in the stock market – it has been adding the volatility. Diversification has still worked in the long run and I’m not ready to throw in the towel on it. We continue to underweight bonds in portfolios. And the bonds we do hold have shorter duration than the overall bond market. But it’s painful in quarters like this where everything gets hit together.
Much like Bruno, bonds may have the power to see into the future. But, like the movie, it doesn’t determine the final destiny. The increased chances of a recession cannot be ignored. But unlike anytime in history, American families and companies are better positioned to handle these challenges. We continue to remain long-term bullish on American companies. Even with rising interest rates and all the headwinds that face us, it’s still the best chance you have against beating inflation.
Disclosures:
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All charts and data from Bloomberg unless otherwise indicated.
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