On Wednesday, August 14, the DOW COLLAPSED 800 POINTS!!!
Translation: the Dow Jones Industrial Average, a stock index comprised of only 30 large U.S. companies, temporarily declined 3%, a feat that has happened eight times in the last five years alone. The decline was triggered by a brief inversion of the 2yr/10yr yield curve, a popular warning signal used by market watchers to predict a near-term recession.
Did I hit the mark on my subtle attempt to mock by far the most over-hyped news headline since the creation of this popular index in 1885? I hope so. While news of this yield curve inversion is worth understanding, far more important for investors is using these market events to better understand the construction and purpose of their investment portfolios.
First we should point out that the short end of the yield curve, the 3mth/2yr curve has already been inverted since March of this year. This inversion occurred because market participants expected that the Federal Reserve would cut the target federal funds rate in an effort to boost inflation and keep the market rally alive. The yield curve is forward-looking and therefore can only be an educated guess. So if market participants believe the Federal Reserve will lower interest rates at a future point in time, let’s say in 6 months, it makes sense that the 6 month yield may be lower than the 3 month yield.
If a portion of the curve has been inverted since March, why the sudden panic regarding an inversion on the 2yr/10yr? The short end of the curve is primarily affected by the Federal Reserve’s interest rate actions, whereas further out the curve reflects the market’s expectations for economic growth and inflation. A recession is defined by two consecutive quarters of GDP contraction and a 10 year treasury yield below the 2 year treasury yield is the markets expectation of a combination of future declining growth and/or a deflationary environment both of which are characteristic of a recession.
Investment portfolios are constructed to weather a full economic cycle including recessions that occur every six to seven years on average. To avoid the futile step of trying to predict and react just prior to a recession we implement a layer of protection into the portfolios in the form of fixed income to protect from the elevated downside risk that equities present. We see this in action on a day like August 14 when Large Cap U.S. Equities return -3% in a single day and Core Fixed Income complements with a +0.43%. So rather than use these bold headlines to focus on the panic of loss, let’s try and observe these events through a different lens, one that shows us that our portfolios are performing exactly as constructed and that our construction was designed to assign the highest probability of reaching your investment goals.
Matt Heimann, CFA
Matt received his Master's Degree in Business Administration from the University of Missouri-Kansas City with a dual emphasis in finance and entrepreneurship. He previously served as a Strategy Analyst for an asset-management firm, and as a bank examiner with the Federal Reserve Bank of Kansas City. He holds a Chartered Financial Analyst designation (CFA).
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