EP 2 | RECESSION WATCH

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ANDREW LANOIE

Hey everyone, it’s Andrew Lanoie and today on the impatient investor recession watch 2020. The market’s favorite recession signal is flashing red again, the US treasury yield curve, one of the most closely watched recession indicators briefly inverted last week and marked the first hints of a recession risk alongside the fears of an economic slowdown.

But before we dig into what happened, what exactly is the US treasury yield curve? Well, very simply put, the yield curve is a plot or storyline of all of the yields on all of the treasury debt sold by the federal government and compares the yields of short-term treasury bills with long-term treasury notes and bonds.
A normal yield curve is when investors are confident, they shy away from long- term notes causing those yields to rise steeply and expect the economy will grow quickly. Mortgage interest rates and other loans follow the yield curve. When there’s a normal yield curve, a 30-year fixed mortgage will require you to pay much higher interest rates than let’s say a 15-year mortgage. If you can swing the payments, you’d be much better off trying to qualify for that 15-year mortgage.

A flat yield curve is when the yields are low across the board. It shows that investors expect slow growth. It could also mean that economic indicators are sending mixed messages and some investors expect growth while others just aren’t sure. When the yield curve is flat, you aren’t going to save as much with the 15-year mortgage. A flat yield curve means the banks probably aren’t lending as much as they should have because they don’t receive a lot more return for those risks of lending out money for 5, 10 and 15 years and as a result, they only lend to low risk customers. They are more likely to save their excess funds in a low risk money market instruments and treasury notes. An inverted yield curve forecast a recession. It’s when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. Investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. These bills, notes and bonds are fixed income investments and they’re issued by the U S department of treasury. They are also called treasuries or treasury bonds for short. Treasury bills are issued for terms less than one year. Treasury bonds are issued for terms of 30 years and treasury notes are issued for terms of two, three, five and 10 years. The treasury also issues treasury inflated protected securities or what they call TIPS. They’re issued in terms of 5, 10 and 30 years and they work similarly to regular bonds. The only difference is that the treasury department increases their value if inflation rises.

The treasury department sells these bills and notes and bonds at auction with a fixed interest rate. When demand is high, bidders will pay more than the face value to receive the fixed rate and when the demand is low, they will pay
less. Treasuries affects the economy in two important ways. First, they fund the US debt. The treasury department issues enough securities to pay ongoing expenses that aren’t covered by incoming tax revenue. If the United States defaults on its debt, then these expenses would not be paid. And as a result, military and government employees would not receive their salaries. Recipients of social security, Medicare and Medicaid would also go without their benefits. It almost happened in the summer of 2011 during the US debt crisis. Second, treasury notes affect mortgage interest rates. The yield curve inverts when investors expect near term an economic risks like an expected recession. The gap between the two year and the 10-year bills is the most closely monitored section of that curve. The inversion is a classic signal of a looming recession.

A curve inversion occurs when a large enough group of investors flocked to long-term bonds. The inflows drive bond prices up and in turn push yields lower. Yield curve inversions have proceeded every U S recession since 1950 through the gap between the two year and the 10-year notes. And on another note, the federal open market committee last week unanimously voted to hold interest rates steady, which is great for real estate investors.

So what are you doing to ensure that your portfolio is going to weather the next recession? Here’s a few key takeaways. During a recession, most investors should avoid investing in companies that are cyclical. These companies pose the biggest risk for doing poorly during tough economic times, and some sectors of real estate are considered more recession resistant than others. And remember, always invest for income.

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