Capital Advisors on Fed, Cash
Capital Advisors Group writes in their latest paper, "With the Fed on Hold and the Yield Curve Inverted, Thoughts on Cash Investment Portfolios," that "The March Federal Open Market Committee (FOMC) decision was a major market event that directly resulted in an inverted yield curve.... The inverted curve may be an overreaction to the Fed's surprise decision and not an indication of an imminent recession. We advise caution on portfolio duration and suggest a laddered portfolio to improve liquidity and reinvestment opportunity. The halt to the Fed's rate hikes could mean a more challenging credit environment. Credit decisions need to be more selective to weather the next downturn." They add, "It is often said that an inverted curve is a reliable forecasting tool for recessions, and it is generally true. Come June, we will have surpassed the longest economic expansion (120 months) in history, so a recession may be long overdue. As we discussed in the January issue, the curve inverted four times in the last four decades, each followed by a recession. However, an inverted curve had no predictive power over the exact timing of the next recession nor market returns during those periods. This is especially significant for cash investors with moderately short time horizons." The piece concludes, "The yield curve inversion we witnessed in recent days may indicate the market's assessment of events that could potentially derail the base case growth projection rather than the health of the economy itself. The swift change in the shape of the curve could indicate an overaction to the surprise March FOMC decision. And recent research revealed that the yield curve needs to be inverted on average over a quarter, not over a few days, to prove reliable. As managers of short-duration institutional portfolios, we are keenly aware of the effect of interest rate gyrations on client portfolios and the undesirable outcome of an inverted yield curve. Unless convinced that interest rate cuts are forthcoming, few investors would be inclined to invest in longer-term securities at lower yields. Our immediate read on last week's yield curve reaction to the FOMC decision is that there was an element of overreaction, both on rate hikes and the balance sheet. Should incoming economic indicators continue to point to less robust but moderate growth, we expect the inversion in the curve to become less pronounced.... What is perhaps a more relevant portfolio consideration is what a halt to the Fed's interest rate decision means for credit investments. Softness in issuances and widening spreads on speculative grade bonds have been in the press for a while, as has the deteriorating credit quality on certain industrial, auto and real estate loans. While a pause in the Fed's decision may offer some relief to these borrowers through lower credit costs, it is also indicative of a more challenging operating and financing environment in a slower economy. Credit decisions on eligible investments should be more selective in order to weather the next downturn."
