Are We Slipping Into A Recession?

wwi

The Maginot Line

A hundred years ago WWI ended. It was a terrible war, fought in Europe with the two main players being Germany and France. Germany invaded France on France’s Eastern boarder. After WWI France decided that Germany wasn’t  going to attack them again like they had just done. So they started building up fortifications along the exact boarder where Germany attacked. This boarder of attack became known as the Maginot Line. A line of fortifications, barriers and weapon installments were built where the Germans invaded. And because the French did not want to offend the Belgians they stopped building the fortifications along the French-Belgium boarder.

Fast forward to WWII. Germany didn’t attack France through the Maginot Lines as it had been fortified. But instead attacked through Belgium. The point is, is that France was preparing to fight the previous war – WWI again. And Germany took great advantage of France’s mistake which hurt France and ten’s of millions of people lost their lives.

“The Last War”

I bring this up because I find that people are fighting what I like to call “the last war.”

I think a good question to ask yourself is “Where is Your Maginot Line?” Where are you looking to the past to protect yourself in the future?

Let’s just presuppose that you are fighting the “last war” in the stock market. You might be a 100% consciously competent person, but whether we like it or not there is a part of us that wants to look to the past, find patterns there, and use those exact same patterns to protect us from the future. This is how our brains are designed. We can’t help doing it by default.

Let’s take a look at a few price charts that show you how a very important and powerful entity is making millions of people fight “the previous war.” And because of this The Fed will continue to hurt ten’s of million of people.

The Federal Funds Rate vs. the U.S. Dollar

In the image below you can see two price charts. The bottom chart shows the Federal Funds Rate and the top chart shows the U.S. Dollar. Those three red vertical lines are when the Fed raised the Federal Funds Rate. The first being in December 2015. Look at how when the Federal Funds Rate was raised, the dollar fell. And then again in December 2016, rates were raised and the dollar popped higher and then fell back down. And then in March 2017 rates were raised again and the dollar started falling again.

Notice that the U.S. dollar is still trying to figure out which direction it wants to go. What you’re seeing in the past 2.5 years is that the dollar doesn’t know which way to move… “Should I move higher…?” Or “Should I move lower…?” It’s still trying to figure out what to do. By the way this is true of any price chart that moves sideways for years. It’s looking for direction.

us dollar vs federal rate

The Federal Funds Rate vs. the 10 Year Federal Treasury Bond

Next let’s look at the Yield on the 10 Year Federal Treasury Bond compared to the Federal Funds Rate. Again, the Federal Funds Rate is the bottom price chart and the top price chart is the 10 Year Bond yield.

You can see that the first time the Fed raised the interest rate, the yield on the treasury fell! And not just a little bit. It fell from 2.3% to 1.3%. Yikes! That probably surprised Yellen. The 10yr Bond yield eventually went back up above the 2.3% rate, but then started falling again after the Feds raised rates two more times.

Remember The Fed “owns” short terms rates. BUT the market “owns” long-term rates like the 10yr and the 30yr.  This means short term rates are going higher, and long-term rates are going lower. In other words as short term rates are going higher, people are buying more long-term bonds. Why is this important? Because when short-term rates are higher than long-term rates then the chance of a recession greatly increases.

federal rate vs 10 year yield

The Federal Funds Rate vs. The 30 Year Treasury Bond

Here’s a chart of the 30 year yield on the US Bond. You can see the same trend as with the 10yr Bond yield. As the Fed raises the Federal Funds rates, the market is buying more long-term bonds and pushing the yield down. This is not good if you want to avoid a recession.

federal rate vs 30 year yield

The Yield Curve

So you may be asking yourself,  “How accurate is this yield-rate-thing?” Look at the price chart below of something called the Yield Curve. The yield compares 2yr yields with 10yr yields. When the 10yr yield is falling more relative to the 2yr yield the price on the chart below falls. The black horizontal line is where short term and long term yields are equal. As long as the price does not dip under the horizontal line – that means that long term yields are higher than short term yields. But if they dip under the zero line (the black horizontal line) then the US is increasing its chance of going into a recession.

short term vs long term yield

But what’s even more interesting is what the upward slopping dotted line it telling us. The dotted upward slopping line is telling us that the yield curve might not need to go negative this time around as it did in the last two recessions. Notice how the yield curve did not go as negative in 2008 as it did in the 2000 Dot Com crash. This means that the yield curve might not even need to zero to spark the next recession.

Protect Your Financial Future by Not Fighting “the Last War”

The yield curve is important because there is a high correlation between US recessions and a flat to “inverted” (when the price goes below zero) yield curve.  When the U.S. goes into a recession, the average stock market correction is 35%.

So what war are you fighting? Are you waiting for the yield-curve to drop to zero or go “inverted?” It may not do that this time before this next recession. Is the Fed fighting a war from the 1980’s and 1990’s? When employment numbers told them a clearer story about the health of Americans. Americans may have jobs but they are very vulnerable to losing those jobs and those jobs are paying a fraction of what they paid 20 years ago. Plus the unemployment rate doesn’t count people that have stopped looking for jobs. What?

What the Fed is looking at may have mattered in the past, but that might be the last war. There are better ways of fighting the next “war.“ Just like France building the Maginot Line in an effort to protect themselves against the last war. I think The Fed is fighting the last war.  The question is what is your Maginot Line? Are you fighting the last war? In other words, are people telling you to diversify and watch valuations metrics like its the 1990’s. Or are you preparing yourself and your money to fight the next war (i.e. the next recession and stock market correction)?

Because you’ll notice that the last war… the 2008-2009 Global Financial Crises when the US stock market fell 58% wasn’t won by having the conventional 60/40 stock/bond split. Those people “only” lost 44% of their money. And it wasn’t won by a well diversified portfolio of different type of stocks. It was won by stepping aside completely from the stock market.

 

In Your Corner,

RCPeck-Dig Signature.JPG     
RC Peck, CFP  

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