The Inverted Yield Curve And A Recession Could Be Extremely Positive

With the 2-year yield higher than the 10-year yield, the yield curve has officially inverted as of 3Q2019. History has shown us there’s a high chance of a recession within the next 6-18 months. I’ll peg the probability at 70%.

To parry a recession, the only thing the Fed can do is to cut rates aggressively from 2.25% down to perhaps 1.6% (where the 10-year bond yield currently hovers) or lower to entice consumers and investors to borrow and get the yield curve closer to normal. Even then, perhaps it’s too late.

When short term interest rates are much higher than long term interest rates, consumers tend to hoard cash and not invest. Why should they when the future looks so cloudy and short-term rates are paying higher than inflation?

Lenders, on the other hand, get squeezed because they have to pay higher short-term deposit rates while earning a lower interest rate on their lending portfolio. As a result, credit standards go up, and even less borrowing and investing occur.

When the velocity of money slows, investment growth, corporate earnings growth, and economic growth also slow. Finally, if enough of us think a recession is on the horizon, then a recession is probably what we’ll get.

Why An Inverted Yield Curve Is Great

Everything is yin yang when it comes to investing. If someone is losing, someone else is gaining.

Given I’m an optimist, let’s take a look at the positives of an inverted yield curve. Let’s see if you are experiencing some of these positives as well.

1) The cost to own a home got way cheaper. As long-term interest rates plummet, so do mortgage rates. In 2014, I took out a 5/1 ARM at 2.5% when I bought my existing primary residence. It was a stellar rate I thought I’d never see again. But here I am, refinancing to a 7/1 ARM at 2.75% just as my mortgage resets.

My payment will go from $3,912/month to $2,859/month partially because I paid down 29.2% of the principal. If I had waited until the 10-year bond yield collapsed to ~1.6%, perhaps I could have gotten 2.5% and reduced my mortgage payment to just $2,766.

In the meantime, the estimated rent for my home has risen from about $4,800/month to $6,200 a month. Even after accounting for property taxes and maintenance, paying about $2,000 less a month to eventually own my house rather than renting is good forced savings.

For those looking to buy an average property, now is the time to go hunting. Inventory is up, rates are down, and people are afraid.

2) Luxury property is going to get clobbered. As the fear of a recession grows, the prices for multi-million dollar luxury homes nobody really needs weaken the most. This is exactly what I’m hoping for in the Honolulu luxury market.

By 2022, we plan to relocate to Honolulu when my boy is eligible for kindergarten. If we can experience a recession in 2020-2021, the timing will be almost perfect for us to buy.

We’ll be able to save for three more years while potentially saving 20% – 25% off the price of a nice Honolulu home. I’m talking about a $1 – $1.5 million discount for the homes I’m targeting. A recession simply exacerbates an already weak luxury property market.

Although my existing properties will also decline in value, they won’t decline in value as much on a percentage basis and absolute dollar basis because I own properties only slightly above the median price here in San Francisco. Besides, I’ve got my fingers crossed the liquidity bonanza starting in 4Q2019 through 1Q2020 will support the SF property market. We shall see!

3) Boring bonds produce decent returns. After I sold one of my SF rental properties in late-2017, I decided to invest about $600,000 in bonds, $600,000 in stocks, and $600,000 in real estate crowdfunding. The idea was to simplify life, earn 100% passive income, and reduce risk.

I decided to go really conservative and buy a smattering of AA-rated zero-coupon or 3%-3.5% yielding California municipal bonds. My goal for my bond portfolio was to earn a boring 3.5% – 4% a year risk-free.

Since purchase, the bonds have indeed paid out 3%-3.5% interest a year. But what I didn’t anticipate was strong capital appreciation on top of the tax-free interest income. Check out some of my bond holdings below.

Municipal bond performance 2019

Not bad right? The second to last holding that shows only +0.61% is a 3-month treasury bond position I bought a couple months ago so that doesn’t count. Even sleepy CMF, the California Muni Bond fund is up about 7.2% YTD while also paying a current 2.2% yield.

If you are a conservative investor with a heavy bond portfolio, you are likely having one of your best years ever with little-to-no volatility or stress.

4) Income-generating assets increase in value. Given interest rates have collapsed, it is now harder to generate an equal amount of income with the same amount of risk, effort, and capital.

For example, back in 2018, a $100,000 10-year treasury bond position could have generated $3,200 a year in interest income. If you bought $100,000 worth of 10-year treasury bonds today, it would only generate about $1,600 a year in interest income.

As a result, any income-producing asset you own that has maintained or grown its income has also appreciated in value. This is why we’ve seen such strong capital appreciation in bonds.

In addition to bonds, assets such as rental property and a cash flow positive business have become more attractive. Smart money should be seeking to buy up such assets. On the flip side, money-losing businesses will probably underperform because of their heightened risk of shutting down.

Let’s say you have a rental property that generates $55,000 a year in income after all expenses. To generate $55,000 a year in income requires $1,375,000 in capital at a 4% rate of return. But if you can only generate a 2% rate of return, you now need $2,750,000 in capital.

Income producing assets increase in value when interest rates decline

During a declining or low-interest-rate environment, it is important to hold onto your cash-generating assets for dear life. If you can buy cash-generating assets for cheap, even better.

5) The wealth gap should narrow. As we learned from my Median Net Worth of Americans post, the top 1% has extended its lead over the middle class. The reason for the widening wealth gap is because the top 1% has invested in assets like stocks and real estate that have rapidly appreciated over the past 10 years.

If there is a recession, the top 1% will get hurt the most. For example, let’s say Warren Buffett is worth $80 billion today and loses 30% of his net worth in the next downturn. The middle class will have caught up to Warren by $24 billion on average. Hooray!

The divergence of wealth between the top 1% and the middle class is unsustainable. Eventually, there will be civil unrest and rioting in the streets if the gap isn’t narrowed.

It is too much to expect the middle class to simply hustle harder, save more, and invest more for their own good. Something is structurally wrong. Instead, we must hope that a recession clobbers the wealthiest people and results in a better wealthy equality equation.

Inverted yield curve - 10-year minus 2-year treasury

Welcome The Inversion With Open Arms

There is always a silver lining in every bad situation. I’m sure some people interested in politics are even hoping for a devastating recession so that the current elected incumbents will lose their jobs.

It’ll be nice to drive on less busy streets, eat at quieter restaurants, and speak to people who have more humility. A recession is truly great if you can figure out a way to lose less than the average person.

We can focus on the negatives or we can focus on the positives. I’ve found that focusing on the positives makes me happier and more optimistic about the future.

Related Post: Personal Lessons Learned Since The Financial Crisis

Readers, what are some other great things that could come out of an inverted yield curve?

The post The Inverted Yield Curve And A Recession Could Be Extremely Positive appeared first on Financial Samurai.

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