On August 14, 2019, the Dow Jones Industrial Average plunged 800 points, losing 3% of its value in its biggest drop of the year. The Nasdaq Composite also lost 3%, while the S&P 500 lost 2.9%.1
The slide started with bad economic news from Germany and China, which triggered a flight to the relative safety of U.S. Treasury securities. High demand briefly pushed the yield on the benchmark 10-year Treasury note below the two-year note for the first time since 2007.2 This is referred to as a yield curve inversion, which has been a reliable predictor of past recessions. The short-lived inversion spooked the stock market, which recovered only to see the curve begin a series of inversions a week later.3
Yield relates to the return on capital invested in a bond. When prices rise due to increased demand, yields fall and vice versa. The yield curve is a graph with the daily yields of U.S. Treasury securities plotted by maturity. The slope of the curve represents the difference between yields on short-dated bonds and long-dated bonds. Normally, it curves upward as investors demand higher yields to compensate for the risk of lending money over a longer period. This suggests that investors expect stronger growth in the future, with the prospect of rising inflation and higher interest rates.
The curve flattens when the rates converge because investors are willing to accept lower rates to keep their money invested in Treasuries for longer terms. A flat yield curve suggests that inflation and interest rates are expected to stay low for an extended period of time, signaling economic weakness.
Parts of the curve started inverting in late 2018, so the recent inversions were not completely unexpected. However, investors tend to focus on the spread between the broadly traded two-year and 10-year notes.4
An inversion of the two-year and 10-year notes has occurred before each recession over the past 50 years, with only one “false positive” in that time. It does not indicate timing or severity but has reliably predicted a recession within the next one to two years. A recent Federal Reserve study suggested that an inversion of the three-month and 10-year Treasuries — which occurred in March and May 2019 — is an even more reliable indicator, predicting a recession in about 12 months.5
Some analysts believe that the yield curve may no longer be a reliable indicator due to the Federal Reserve’s unprecedented balance sheet of Treasury securities — originally built to increase the money supply as an antidote to the Great Recession. Although the Fed has trimmed the balance sheet, it continues to buy bonds in large quantities to replace maturing securities. This reduces the supply of Treasuries and increases pressure on yields when demand rises, as it has in recent months.6
At the same time, the Fed has consistently raised its benchmark federal funds rate over the last three years in response to a stronger U.S. economy, while other central banks have kept their policy rates near or below zero in an effort to stimulate their sluggish economies. This has raised yields on short-term Treasuries, which are more directly affected by the funds rate, while increasing global demand for longer-term Treasuries. Even at lower rates, U.S. Treasuries offer relatively safe yields that cannot be obtained elsewhere.7
The Fed lowered the federal funds rate by 0.25% in late July, the first drop in more than a decade. While this slightly reduced short-term Treasury yields, it contributed to the demand for long-term bonds as investors anticipated declining interest rates. When interest rates fall, prices on existing bonds rise and yields decline. So the potential for further action by the Fed led investors to lock in long-term yields at current prices.8
Even if these technical factors are distorting the yield curve, the high demand for longer-term Treasuries represents a flight to safety — a shift of investment dollars into low-risk government securities — and a pessimistic economic outlook. One day after the initial two-year/10-year inversion, the yield on the 30-year Treasury bond fell below 2% for the first time. This suggests that investors see decades of low inflation and tepid growth.9
The flight to safety is being driven by many factors, including the U.S.-China trade war and a global economic slowdown. Five of the world’s largest economies — Germany, Britain, Italy, Brazil, and Mexico — are at risk of a recession and others are struggling.10
Although the United States remains strong by comparison, there are concerns about weak business investment and a manufacturing slowdown, both weighed down by the uncertainty of the trade war and costs of the tariffs.11 Inflation has been persistently low since the last recession, generally staying below the 2% rate that the Fed considers optimal for economic growth. On the positive side, unemployment remains low and consumer spending continues to drive the economy, but it remains to be seen how long consumers can carry the economic weight.12
Regardless of further movement of the yield curve, there are likely to be market ups and downs for many other reasons in the coming months. Historically, the stock market has rallied in the period between an inversion and the beginning of a recession, so investors who overreacted lost out on potential gains.13 Of course, past performance does not guarantee future results. While economic indicators can be helpful, it’s important to make investment decisions based on your own risk tolerance, financial goals, and time horizon.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. The performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in any index.
The shift from further rate increases this year suggests that the Fed believes there is little to fear regarding high inflation.
At its meeting on March 20, 2019, the Federal Open Market Committee (FOMC) maintained the benchmark federal funds rate at the target range of 2.25% to 2.50% that was set in December 2018. This in itself was not surprising. But other communications signaled a definite hiatus in the Fed’s policy of raising interest rates and tightening the money supply.1
The FOMC has raised the funds rate nine times since December 2015, with four increases in 2018 alone. As recently as September 2018, the committee projected three more increases in 2019. That dropped to two projected increases at the December meeting. But the March projections suggest that there may be no rate increases in 2019 at all.2
The FOMC also indicated that it would slow its program of reducing excess reserves of Treasuries and other government securities that were built up during and after the recession in a policy known as quantitative easing. The reduction program will stop after September 2019 unless conditions change, reflecting the Fed’s belief that there is no need for further tightening of the money supply.3
The strongest communication to come out of the March meeting may be the unusually direct comments from Fed Chairman Jerome Powell. “We don’t see data coming in that suggest we should move in either direction,” he said. “They suggest that we should remain patient and let the situation clarify itself over time….It may be some time before the outlook for jobs and inflation calls clearly for a change in policy.”4
Powell’s reference to jobs and inflation reflects the Federal Reserve’s dual mandate to foster maximum employment and price stability. The FOMC sets monetary policy in accordance with the mandate, using two primary tools: the federal funds rate and the monetary supply.
The federal funds rate is the interest rate at which banks lend funds to each other overnight to maintain legally required reserves. The funds rate serves as a benchmark for many short-term rates set by banks, including the prime rate, which in turn influences consumer rates such as auto loans and credit-card rates. It can also influence longer-term rates.
Theoretically, lowering interest rates and increasing the money supply will stimulate the economy, which is why the Fed took these measures during the recession and extended them through the long, slow recovery. (The federal funds rate was near zero for eight years, from December 2007 to December 2015.)
On the other hand, raising rates and tightening the money supply are intended to slow the economy, primarily to control inflation. In theory, a strong economy with low unemployment should put workers in a position to demand higher wages, and higher wages allow businesses to raise prices on their products, which allows them to expand and pay higher wages.
A moderate level of wage and price inflation is considered integral to a healthy economy, and the Fed has set a goal of 2% annual inflation as optimal for economic growth. However, despite a strong labor market, wages and the broader economy have not grown as quickly as expected, and inflation has generally remained below the 2% target. Thus, raising rates has been more of a preventive measure and return to historical norms than a response to an overheated economy or runaway inflation.
The shift from further rate increases suggests that the Fed believes there is little to fear regarding high inflation. In fact, Powell said that the greater danger is low global inflation, calling it “one of the major challenges of our time.”5While the Fed has raised rates steadily over the last three years — providing flexibility to drop rates if necessary — central banks in other countries have been slow to act due to sluggish economies and low inflation. Some have kept their benchmark rates below 0%, creating a risk of asset “bubbles” and placing them in a difficult position in the event of an economic downturn.6
The stock market rose moderately after the FOMC announcement, which came just two hours before the close of the New York Stock Exchange, but stocks still closed with a small loss for the day. The market generally applauds lower interest rates, but investors continue to be jittery about the potential for global economic weakness. In the longer term, stable interest rates at current levels may be good for stocks, which began to rally on January 4, 2019 — when Powell first preached “patience” — and gained more than 15% through March 20.7
The reaction in the bond market was stronger. The prospect of lower rates for an extended period — along with the Fed’s decision to keep more Treasuries in its portfolio — made current yields more appealing. Investors rushed to buy Treasury securities and other bonds, driving prices up and yields down. The yield on the 10-year Treasury note fell to 2.52%, the lowest level in 15 months and just seven basis points (0.07%) above the yield on the three-month T-bill — nearing a “yield curve inversion” considered by some economists to predict a recession. Two days later, on March 22, the curve inverted for the first time since 2007, with demand for longer-term bonds driven by soft global growth.8
Although pessimists have feared a new recession for years, Powell emphasized that the U.S. economy is “in a good place,” and the official FOMC policy statement pointed to “sustained expansion of economic activity” in its expectations for future economic direction.9-10 A potential pause in rate hikes this year does reflect some concern about economic growth, but it also suggests that the Fed believes the current level is a neutral rate where further movement up or down could have a negative effect. This is not necessarily cause for concern. It may just mean that the Fed is doing its job.
The return and principal value of stocks and bonds fluctuate with market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasuries are guaranteed by the U.S. government as to the timely payment of principal and interest.
1-3, 10) Federal Reserve, 2018-2019
4-5, 9) Bloomberg, March 20, 2019
6) The Wall Street Journal, March 21, 2019
7) The New York Times, January 4, 2019; March 20, 2019
8) MarketWatch, March 20 and 22, 2019
If you own a home and have equity in it, you might consider taking out a home equity loan as a source of funds for your child’s college expenses. Alternatively, you might decide to refinance your mortgage to one with a lower interest rate or a longer term in order to create more discretionary income each month that can be used for education purposes. To qualify for a home equity loan or mortgage refinancing, you usually need a good credit history.
Mortgage refinancing refers to the process of taking out a new home mortgage and using some or all of the proceeds to pay off an existing mortgage. The main purpose of refinancing is to save money by taking advantage of lower interest rates or to lower monthly payments by extending the term of the loan. By doing so, you free up money that can immediately be used for education expenses.
There are actually two types of refinancing: a no-cash-out refinancing and a cash-out refinancing. A no-cash-out refinancing is when the amount of the new loan doesn’t exceed the mortgage debt you currently owe, plus points and closing costs. You can generally borrow up to 95 percent of your home’s appraised value with this type of refinancing.
A cash-out refinancing is when you borrow more than you owe on your current mortgage. You can then use the excess proceeds however you wish. Many people use this type of refinancing to pay off other outstanding loans. However, you are generally limited to borrowing no more than 75 to 80 percent of your home’s appraised value with this type of refinancing.
Keep in mind that closing costs are charged when you refinance your mortgage (points, application fees, filing fees), but lenders may eliminate these costs in an effort to gain your business. And, of course, your home serves as collateral for the new mortgage, just as with your original mortgage.
Home equity financing uses the equity in your home to secure a loan. It is structured as either a home equity loan or a line of credit.
With a line of credit, the lender establishes a credit limit, which depends on the equity in your home and your ability to make payments. You can then access as much money as you need (up to the limit), whenever you need it, by writing a check or using your credit card. Generally, interest rates are variable and tied to an index. Your monthly payments will also vary, depending on your outstanding balance.
With a home equity loan (often referred to as a second mortgage), you borrow a fixed amount (typically no more than 80 percent of the equity in your home), which is transferred to you in full at the time of the closing. You must then repay that amount over a fixed term. If you repay the loan, the lender discharges your mortgage. If you do not repay the loan, the lender can foreclose on your home to satisfy the debt.
Home equity financing generally means a more favorable interest rate compared to an unsecured, personal loan, because your home secures the loan.
The major disadvantage of home equity financing is that your home is at risk because it serves as collateral for the loan. As such, the lender can foreclose on your home if you fail to repay the loan.
If you need to borrow funds for college, a home equity loan might be appropriate. Compare the interest rate you can get on a home equity loan or line of credit with the cost to borrow elsewhere. If you think there is any chance you will have difficulty paying the loan back in the future, you should think twice. A home equity loan or line of credit is secured by your house, and the lender can foreclose on it if you default.
The decision whether to refinance your mortgage is usually dependent on current mortgage rates. If the current rate is more favorable than the rate of your current mortgage, the decision to refinance will likely hinge on whether you expect to stay in your current home long enough to recoup the costs of refinancing. You might also choose to refinance to a mortgage with a longer term in order to lower your monthly mortgage payment. For example, you now have a 15-year mortgage but will refinance to a 30-year mortgage.