Page 17 - ISQ UK_October 2017

OCTOBER 2018

The Calm Outlasts the Storm:
Expansion and Recession Lengths

The economic business 11.2 62.2
cycle goes through periods of expansion Average
and growth, as well as periods of Aug 1957 – April 1958 8 39 Months in recession
contraction and recession. A recession April 1960 – Feb 1961 10 24 Months in expansion
can be severe or mild. It does not mean Dec 1969 – Nov 1970 11 106
that there is necessarily an economic Nov 1973 – March 1975 16 36
collapse, but signals that economic 6 58
activity has declined for several months Jan 1980 – July 1980 16 12
and/or consecutive quarters. July 1981 – Nov 1982
July 1990 – March 1991 8 92
March 2001 – Nov 2001 8 120
Dec 2007 – June 2009 18 73
0 25 50 75 100 125
Source: Federal Reserve Bank of St. Louis; Raymond James, as of 09/15/2018

recessionary periods. That margin has widened in recent history. Over take precedence over the shape of the yield curve, continued rate
the last 30 years, expansionary periods are, on average, more than 8.6 hikes increase the possibility of an inverted curve and, with it,
times the length of recessionary periods. concerns of a recession. If the Fed pushes short-term rates too high
too fast, it could cause the yield curve to invert. Keep in mind that the
Experts in the fixed income space often monitor spreads between Fed has relatively less influence upon intermediate and long-term
different points on the yield curve in order to forecast economic trends rates. Should short-term rates rise above intermediate and long-
and investor behavior. For example, many prefer to look at the spread term rates, economic models and investor sentiment may very well
between the yield on the 2-year Treasury and the 10-year Treasury. turn an inverted yield curve into a self-fulfilling prophecy and thereby
The graph on the following page illustrates the 2-year versus 10-year ‘will’ the economy into a recession.
Treasury spread (light blue line) and the federal funds rate (dark blue
line) over the past 30 years. When the light blue line falls below the
horizontal ‘0’ axis, the yield curve has become inverted. This 30-year WHERE DO THEY GO?
timeline includes four periods of major Fed rate hikes, three periods of There are currently more headwinds than tailwinds for intermediate
major Fed rate cuts, three recessions, and three inverted yield curves. to long-term interest rates. As a result, they are likely to be range
bound. We anticipate the yield on the 10-year Treasury to remain
THE FED’S ROLE range bound between 2.80% and 3.40%. Given that the economy
continues to show solid growth, there is reason to believe the Fed
The Fed attempts to keep the markets stable by staving off will continue its gradual pace of hikes and that intermediate and
economic instability caused by inflation or deflation. At the risk long-term rates will not keep pace, thus causing a yield curve
of invoking the phrase ‘this time is different,’ one of the more inversion. With U.S. fundamentals still relatively strong, the reaction
dangerous mantras of our industry, this time just may be different to of the market will dictate where we head from there.
a certain degree. Unlike the last three periods of previous rate hikes
by the Fed, this time the hikes began after over seven years of
interest rates at 0%. As a result, the Fed may be less focused on an INVESTING AMIDST INVERSIONS
overheated market and more focused on reaching ‘neutral’ interest When creating a fixed income strategy/allocation, investors would
rates after a period of unusually low rates. A 3.00% federal funds rate do well to focus on long-term planning rather than attempting to
is widely viewed to be ‘neutral’ by policymakers. This would entail predict future rates.
another four or five rate hikes of 25 bp each. The Fed raised rates in A common response to a flatter yield curve is to invest in bonds with
September and a December hike is looming. These hikes alone could shorter maturities. However, an inverted curve does not necessarily
induce the yield curve to invert. mean that short maturity bonds are optimal. For example, on 3 July,
Some Federal Reserve presidents have stated that their greatest 2000, the 2-year Treasury yield of 6.29% was higher than the 10-year
concern is inflation, not necessarily the shape of the yield curve. Treasury yield of 5.99%. However, after maturity on 3 July, 2002, the
They are more worried about high inflation than low inflation. These funds from the 2-year Treasury would need to be reinvested. Here,
statements remind us that the Fed’s mandate is to create a stable investors faced a much different rate environment. By that time, the
monetary environment. Given that this mandate will continue to yield on the 2-year Treasury had fallen to 2.79% and the yield on the

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