Until September, 2023 has been a great year for the stock market. All the major market indexes are positive for the year, some are up double-digits. The job market is strong, and inflation is coming down, at least that’s what the monthly reports are saying. My family grocery bill would disagree though. So, I guess we can all sit back, relax, and enjoy the ride of another economic boom and multi-year bull market.
But wait a minute, there’s one teeny, tiny issue. The bond market doesn’t seem to agree. Bond yields (interest rates) are at multi-year highs with shorter-term interest rates higher than longer-term interest rates. What the heck is going on?
Before moving on, it would help to know a little about how bonds work. Bonds are sold by companies and the government to fund operations. They are essentially borrowing money with the promise to pay it back in a certain amount of time. In return, bonds pay the buyer a guaranteed amount of interest annually in exchange for lending the money. The interest rate that the borrower must pay is based on the length of the bond as well as the financial strength of the company and is fixed when the bond is first issued.
Once bonds are issued, they trade in the open market similar to stocks. Both the price and yield (interest rate) of bonds trading on the open market fluctuate. Things get technical from here, but just understand this; as bond prices go up, bond yields (interest rates), go down. When bond prices go down, bond yields (interest rates) go up.
So, when longer-term bond interest rates are going up, it may mean that investors have confidence in the economy and therefore are selling bonds. Typically, the stock market rises during times like these. The reverse is also true. When longer-term bond interest rates are going down, investors may have concerns about the economy and buy bonds seeking the protection and stability that they may offer. Typically, the stock market falls during times like these.
Normally, longer-term interest rates are higher than shorter-term interest rates due to the higher risk associated with lending money over a longer period. But what does it mean when shorter-term interest rates are higher than longer-term interest rates? Hmm?
When shorter-term interest rates are higher than longer-term interest rates, it is referred to as an 'inverted yield curve.' This situation is relatively uncommon but can have significant implications for the economy and financial markets. When shorter-term rates exceed longer-term rates, it suggests that investors have concerns about the near-term economic outlook. An inverted yield curve often indicates expectations of an economic slowdown or contraction (recession). It suggests that investors are seeking the safety of longer-term bonds, driving their prices up and yields down.
This inversion can impact various sectors of the economy. For example, it may discourage borrowing and investment, as higher short-term rates make it more expensive for businesses and individuals to access credit. As bond yields increase, so do interest rates on loans, including mortgages, business loans, and consumer credit. Higher borrowing costs can discourage businesses from investing in expansion, limit consumer spending, and slow down economic growth. Additionally, it can affect the profitability of banks and other financial institutions that rely on borrowing at short-term rates and lending at long-term rates.
It is important to note that an inverted yield curve does not guarantee a shrinking economy (recession), but it is often seen as a warning sign. Economists and policymakers closely monitor this phenomenon as it can provide insights into the health of the economy and potential future trends.
This is where it gets interesting. Normally, rising bond yields lead to a decrease in asset prices, particularly in the stock market. As bond yields rise, investors generally shift their investments from stocks to bonds, seeking higher, guaranteed returns with less risk. This results in a decline in stock prices, negatively affecting investor portfolios and potentially leading to a decrease in consumer wealth and confidence.
So, what’s going on this year? The yield curve has been inverted since July 2022 indicating expected weakness and possible recession, yet the market overall is up, and some parts are up double-digits. Who will win this economic tug-of-war?
Truth is, nobody knows for sure. While bond yield can be one of the many factors considered by investors when making investment decisions, it is not a foolproof predictor of stock performance. There are various factors that can influence stock prices, including company-specific factors, market sentiment, etc. Additionally, some sectors of the economy are even considered defensive and are somewhat resistant to economic downturns. Consumer goods for example. Why? Because most people don’t stop brushing their teeth, washing their clothes, or talking on their smartphone during economic downturns? Therefore, the stocks of those types of companies tend to hold up a bit better. That doesn’t suggest that they don’t drop in value. What it suggests is that they may not drop in value quite as much as stocks in more economically sensitive sectors like technology and financials.
So, who’s right, the bond market or the stock market? Will the economy go into recession, as the bond market is indicating, causing the stock market to reverse course and give back gains or will the economy slow, but not shrink, thereby propelling the stock market to new highs? What’s an investor to do?
As I’ve said before, if you’re between the ages of 20 and 50, continue what you hopefully have been doing; maximize the funding of your IRA and employer retirement plan (especially the Roth). Buy quality companies, reinvest dividends, minimize your taxes, and avoid excessive debt. Enjoy life but keep an eye on your future. I call this philosophy Live Well-Retire Better™.
For those 50+, retired or near retirement, I suggest a slightly different approach. As we age, our emotions play a much larger part in our decision-making process, especially about our money. We must get emotions out of the way. Consider changing your investment approach to be a bit more defensive when the data suggests it may be time to go around the storm rather than through it. Heed the bond market warnings. Error on the side of caution. I call this approach Tactiful™ Investing. It combines the principles of buy and hold with those of a more defensive or tactical approach.
Is 2023 an anomaly or will the bond market be proven right? Only time will tell. In the meantime, enjoy life. Tomorrow is a gift. Live Well-Retire Better™.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. LakePointe Advisors does not provide legal or tax advice.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. A Roth retirement account offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth account must be in place for at least five tax years, and the distribution must take place after age 59½, or due to death or disability. Depending on state law, Roth accounts distributions may be subject to state taxes.
Advisory services offered through Fourth Dimension Wealth LLC, a Registered Investment Advisor. LakePointe Advisors LLC and Fourth Dimension Wealth LLC are separate entities.
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