TSP

Chicago - June 4 2019: Federal Reserve Chairman Jerome Powell spoke at a conference involving interest-rate policy strategy and hinted it might cut rates to extend economic expansion if needed.

Lyn Alden

This past week was complicated for the markets, with several factors pulling both up and down. Overall, it ended up being a strong week with a good upward trend.

Chart Source: Google

The S&P 500 (tracked by the C Fund) started the week mildly down on Monday as investors continued to shift into less volatile assets amid concerns that the U.S. economy is weakening and that trade wars may be intensifying.

On Tuesday, Fed Chairman Powell stated that the Federal Reserve would “act as appropriate to sustain the expansion.” Many investors and analysts took this to mean that the Federal Reserve is ready and willing to cut interest rates if the economy weakens, which would be stimulatory in the short term. This helped the market rally for the remainder of the week.

On Friday, the Bureau of Labor Statistics released a weaker-than-expected monthly jobs report, with just 75,000 jobs created. The consensus estimate compiled by Bloomberg was that 175,000 jobs would be created, so the released number fell far short of expectations. Additionally, the BLS revised down their previously-reported April and March’s numbers by significant amounts, meaning that fewer jobs were created than originally reported in those earlier months.

Also on Friday, President Trump announced that he will indefinitely suspend his recently announced tariffs on Mexico, due to an agreement by Mexico to work on border security and immigration. When these tariffs were announced in the week prior, it resulted in a significant negative hit to the stock market. So, this impact has seemingly been taken off the table going forward.

Fed Policy, Interest Rates, and the G Fund

The Federal Reserve usually raises short-term interest rates during economic expansions to keep inflation in check and to avoid market excesses. In contrast, they generally cut short-term rates if the economy appears to be weakening, in an attempt to stimulate it and promote borrowing.

Usually, bonds with a longer duration have higher interest rates than bonds with a shorter duration, because investors take on more risk about future unknown factors, like inflation or default risk. But when the bond market starts to suspect that the economy is weakening and that the Fed will cut rates, they often invest more heavily into longer-duration bonds, which pushes their yields down. This has been happening recently, which has unfortunately driven down the G Fund interest rate.

Therefore, the difference between long-term rates and short-term rates tends to decrease or even invert the later an economy gets into an expansion cycle. This chart shows the difference between 10-year and 2-year Treasury bonds over the past 40+ years, and demonstrates the pattern well:

Chart Source: St. Louis Fed

On this chart, the blue line is higher when there is a big difference between the interest rates of 10-year and 3-month Treasury bonds, which is healthy. The blue line goes down when that gap narrows, which is a less healthy situation for the financial industry and the general economy. It tends to hit zero within a year or two of a recession, with recessions shaded in gray on the chart.

When the Fed starts cutting short-term rates in response to a slowing economy, the difference historically tends to widen immediately, which is why the blue line starts going up right before recessions.

The U.S. stock market is currently in pretty good shape, and not too far off recent all-time highs. However, recession indicators seem to be building.

Nothing is for certain, but when times are good and storm clouds are visible on the horizon, it’s a good time to make sure your portfolio is appropriately diversified for your age and risk tolerance. This sounds like obvious advice, but various surveys and the government shutdown earlier this year all show that many people are unprepared for periods of economic weakness.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.