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Falling Interest Rates Prompt Continuing Volatility

August 14, 2019

August's higher market volatility continued Wednesday (Aug. 14) as stocks dropped in tandem with long-term interest rates. In six of the last eight trading days, the Dow has moved 1% or more. But remember that market volatility is a door that swings both ways – on those six days, the Dow rose more than 300 points three times and fell more than 300 points on the other three days.?

Don't let this bout of volatility shift your attention from the positive fundamentals. The economy and corporate earnings are growing, supported by solid job growth, low interest rates and easier monetary policy globally.?

Flatter yield curves ahead?

After rising sharply in response to Aug. 13's announcement that some tariffs on Chinese imports would be delayed until December, stocks reversed and dropped 3% on Aug. 14 due to worries that falling long-term rates may be signaling a recession ahead:

  • The Dow dropped 800 points or 3%, its biggest decline in 2019.
  • The 30-year U.S. Treasury bond rate reached a record low just above 2%, reflecting concerns about slower global economic growth, negative foreign interest rates and still-high trade tensions.?
  • As long-term interest rates fell, the 10-year Treasury rate edged below the two-year rate for the first time since 2007, refueling worries that an inverted yield curve (when long-term rates are lower than short-term rates) is signaling an approaching economic storm. Today's fears focused on the inverted yield curve, but this signal isn't new. The 10-year Treasury rate has been below the three-month bill rate since May, and it's a more reliable indicator.

Falling long-term rates and an inverted yield curve are cautious signals that should not be dismissed. In the past, the inverted yield curve (using the three-month bill rate) has been a reliable signal of a recession. However, it's not very timely, since it has led a market peak by an average of nine months and a recession by 16 months, ranging from six months to more than three years.?

Fundamentals matter

Lower interest rates globally, helped by expectations of additional Federal Reserve rate cuts, are also an input to the economic engine. To the extent low rates offer support to the economy, this is broadly supportive for the stock market over time. As a result, we think the fears have run well ahead of the fundamentals, which is why we recommend staying invested in an appropriate mix of stocks and bonds based on your comfort with risk and goals. Remember that fixed-income investments play an important role in your portfolio because they can help reduce the swings in the value of your investments during times of higher market volatility like the last few days.?

We're not surprised market volatility has picked up as overall economic and earnings growth has slowed and interest rates have declined. But a focus on daily fluctuations or worrisome headlines obscures the broader investment landscape, which remains reasonably favorable:

  • Economic growth is likely to remain positive for a while longer.
  • Corporate earnings are still reasonably supportive.?
  • Stock market valuations are attractive.?
  • Monetary policy is becoming more stimulative, not restrictive.

In our view, this is a recipe for the bull market to be extended, but with more bouts of indigestion along the way, just as we've seen several times over the past few years.?

Craig Fehr, CFA?

Kate Warne?Ph.D, CFA

Investment Strategists

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