This article appeared in Physicians Practice.
Just as faithful physicians abide by the Hippocratic oath to “Do no harm,” wise investors abide by the maxim “Don’t fight the Fed.”
The Federal Reserve is the Central Bank of the United States and exerts tremendous influence over the economy and therefore investment prices. “Don’t fight the Fed” is a principle as fundamental to investing as the Hippocratic oath is to medicine.
When the economy is hurting, the Federal Reserve functions like a physician administering potent analgesia in the form of low interest rates. Low interest rates for loans and bonds stimulate the economy and make bonds less attractive investments. Combined these bolster stock market prices. When the Federal Reserve aggressively lowers interest rates, wise investors “Don’t fight the Fed” and buy stocks.
Conversely when the Federal Reserve aggressively raises interest rates, wise investors “Don’t fight the Fed” and remain vigilant for recessions and accompanying stock market pain. Before the pain comes signs of dependency which include investment bubbles and inflation. Recently inflation surged to over forty-year highs around 8% annually. In order to counter inflation, the Federal Reserve began increasing interest rates. Eventually a tipping point in interest rates will be reached, and a new recession will ensue. When the Federal Reserve aggressively raises rates, wise investors remain vigilant for economic and stock market pain.
Predicting pain can be challenging. However, each of the last four recessions was preceded by long term treasuries (ie 10 years) yielding less than short-term treasuries (ie 3 months), a situation referred to as a treasury yield inversion. Treasury yield inversions occurred within eighteen months before each of the last four recessions, and three out of the last four recessions saw a bear market in stocks (the 1990 recession was unaccompanied by a stock bear market).
10 Year Treasury minus 3-Month Treasury. Recessions are depicted in gray. Note the inversions occurring before each of the last four recessions.
Source: Federal Reserve Economic Data https://fred.stlouisfed.org/series/T10Y3M
This apparent paradox- short-term bonds yielding more than long-term bonds- is a sign smart money is preparing for a recession. Specifically, the Federal Reserve predictably applies the same analgesia of low interest rates during recessions. If you possess bonds that expire in a recession when interest rates are low and you wish to continue investing in bonds, you will need to purchase bonds paying low interest rates. Smart investors avoid this by selling short-term bonds before a recession, and purchasing long-term bonds. Bond yield moves inversely to a bond’s price; therefore mass purchasing of long-term bonds and selling of short-term bonds pushes long-term yields temporarily below short-term yields.
Just as faithful physicians abide by the Hippocratic oath to “Do no harm,” wise investors abide by the maxim “Don’t fight the Fed.” Recent record inflation indicates that the economy is dependent upon the analgesia of low rates, and the Federal Reserve has responded by increasing interest rates. While predicting the next bout of economic and stock market pain is difficult, wise investors will note that treasury inversions occurred within eighteen months of the last four recessions.
This article reflects the current opinion of the author. All opinions expressed in this article reflect the judgment of the author at the time of publication and are subject to change. The article is based upon sources believed to be accurate and reliable. Opinions and statements about the future expressed in the report are subject to change without notice. Do not assume any information contained in this article serves as receipt of investment advice or a substitute for personalized investment advice from Brian Gabriel. The report is not a solicitation or an offer to buy or sell any security.