MEMOS FROM THE RATES MARKETS AUGUST 2019 US interest rates have declined rapidly in the last several months and the yield curve has flattened and even inverted .A combination of weaker global growth, faling foreign yields, and risks to the market plumbing systems are the cause The most likely resolutions to market plumbing risks are sharper Fed rate cuts, mini-QEs, or deaker sales of risky assets Should US economic data paint a more negative picture, we'll almost certainly retest all-time low yields from 2016 1. GLOBAL ECONOMIC DETERIORATION While contemporaneous economic data in the US have trended well in recent months, there is plentful evidence of economic detenioration across the globe. Much of this deterioration appears trade related, with heavily export-relant countries such as Germany and China experiencing the most obvious slowing. Slower economic growth (or even a global recession) reduces corporate profitability. spurs central bank rate cuts, and increases demand for low-risk assets, all three of which have the impact of encouraging demand for bonds 2. FEDERAL RESERVE The Federal Reserve has executed a complete U-turn in policy over the past 12 months, going from raising rates in a lock-step quarterly patten to cutting them almost haphazardly. Signals from the US central bank have the markets pricing in addtional rate cuts in September through December 2019. When the Fed cuts, longer-term interest rates tend to fall and, f the markets believe the Fed is not cutting rates fast enough to avoid recession, long-term rates tend to fall faster than short-term rates, and the yield curve inverts. Most maturities are currently inverted, meaning that shorter-term bonds yield more than longer-term bonds 3. FOREIGN INFLUENCE Yields on overseas bonds-particularly German bunds, Japanese Govermment Bonds, and UK Gits-have an influence on Treasuries. Bund yields in particular have been on an incredble run, going from about 000 % at the end of April to -071% today Intraday trading action suggests buying in bonds has been leading buying in Treasuries quite consistently throughout this period. One common misconception is that Treasuries look attractive to Euro-based investors owing to their higher nominal yields (153 % vs -071% in the 10-year maturity) The reality, howevet, is that currency hedging costs more than eat up this differential and the inverted shape of the U.S. yield curve actually makes Treasuries unattractive to Euro-, Yen-, and Pound sterling-based investors. 4. MARKET PLUMBING The confluence of many factors-tighter bank capital and liquidity regulations, heavy Treasury issuance to fund budget deficits, the inverted yield curve, and currency hedging costs-are creating problems in financial market plumbing. Plumbing refers to the flow of liquidty (money) on a short-term basis. Understanding how these flows work requires a high degree of financial system knowledge, and the complexities have been grown of late. Understanding these complexities is also how we reached the conclusion that the Fed's balance sheet reduction would end early, Complex systems foil in complex ways IN CONCLUSION: Just as higher yields fed back into the financial markets and economic outlook 10 months ago, lower yields and a flatter yield curve are doing the same. Historically. falling yields coupled with an inverted yield curve has been a good predictor of recession (although a poor predictor of recession timing) Essentially, an inverted curve signals that the Federal Reserve is very likely to cut interest rates in the future. and the Fed typically cuts when there is an imminent economic slowdown. Markes aiready knew of a high probability of rate cuts, thanks to Fed commentary, so the inversion just doubles-down on that expectation. While funding costs for the corporate sector have come down somewhat, uncertainty created by global growth risks and a highly uncertain trade policy cutiook have limited the pass-through effects of lower interest rates into the real economy. Moreover, the rapidity of the yield decline appears to be creating incremental uncertainty, as the business community is womied the bond markets "know something" about the economic outlook The one positive exception to the transmission of Fed easing into the economy is, perhaps, lower mortgage rates, which should support housing sales short term and free up consumer income via refinancings Regular readers will recognize that we called for "peak interest rates" in late 2018 and came into 2019 modestly bulsh on the bond markets. with the caveat that, if we were wrong, it was because rates would fall below our forecast That caveat was borne out, although the recent rapid decine means that yields are below even the downside range of our forecasts. As Nobel laureate Paul Samuelson-oten errantly attributed to Keynes-once said, "When events change, I change my mind. What do you do?" Events are changing very rapidly. Fed action and market plumbing problems mean that overnight interest rates now have a chance of revisiting the zero lower bound as early as 2020, and long-term interest rates have a chance of pushing through their contemporary era lows. For the 10-year note, that would mean yields below the 136% reached in July 2016, shortly after the 2016 Brexit referendum After all, we are trading less than 025 % above that level today In conclusion, the recent downdraft in yields is reflective of a number of factors: A souring global economic outlook, a high probability of further Fed rate cuts, faling yields abroad, and risks to the market plumbing Implications for the economic outlook from falling yields and a fiatter yield curve are not favorable, as yield curve inversions frequently precede recessions. Finaly, it is worth pointing out that yields have fallen wel in advance of any large negative trends emerging in US. economic data. If those contemporaneous data do turn negative, we will almost certainly return to the record low yields reached in 2016, but the situation remains fluid Th pordu tyeay vesment Sagy Grouo e vedectu groperty of Jaey Mongomey Sonucuaeandayobe eoroduced d or puokshed by any person tor anygugose wt Jaeys eess nwn cosent The neportis to be sedt oioal ouses only in no event shou ebe coned s solcon or ser to uche or set a security The itamton peesene heess o sources beteed berele tut net gateed Oy Janeys to acuracy or oneeness Aey se nmet o es meroned ae ed for ue purposes on and ma not represet the spectic res or securtes wale at a en e himny of See finsl Oficial Staements orhopect for any new umetioned heren are a uet the w of nd nce o invetnents ny vary becae of changes in m ig echenge s securites prins maet ndeen we n centional or nc conons of us or ner tos Ptpeoce snotecessyde are petomance For investment adwce spectic o your stuon oror addsonomon on s o e toics, please coct your Jaey FAano your tas eg ov THE STIRLING GROUP The Stiling Group was founded on a simple belief that everyone's economic and life situation is unique. We keep that simple principle at the forefront when creating tailored financial plans for our clients. As veteran Financial Advisors, we have vast experience researching the marketplace and advising our clients on the products and services that best meet their needs. We are dedicated to learning about your personal goals, and together we will use that information to build a solid financial plan focused on your specific needs. atJa Montgonny S LLC Janney THE STIRLING GROUP AT JANNEY MONTGOMERY SCOTT LLC 2200 Georgetown Drive, Suite 400, Sewickley, PA 15143 www.TheStirlingGroupAdvisors.com 724.934.2953 in JANNEY MONTGOMERY SCOTT LC MEMBER NYSE, FINRA SPC www.ANNEY.COM MEMOS FROM THE RATES MARKETS AUGUST 2019 US interest rates have declined rapidly in the last several months and the yield curve has flattened and even inverted .A combination of weaker global growth, faling foreign yields, and risks to the market plumbing systems are the cause The most likely resolutions to market plumbing risks are sharper Fed rate cuts, mini-QEs, or deaker sales of risky assets Should US economic data paint a more negative picture, we'll almost certainly retest all-time low yields from 2016 1. GLOBAL ECONOMIC DETERIORATION While contemporaneous economic data in the US have trended well in recent months, there is plentful evidence of economic detenioration across the globe. Much of this deterioration appears trade related, with heavily export-relant countries such as Germany and China experiencing the most obvious slowing. Slower economic growth (or even a global recession) reduces corporate profitability. spurs central bank rate cuts, and increases demand for low-risk assets, all three of which have the impact of encouraging demand for bonds 2. FEDERAL RESERVE The Federal Reserve has executed a complete U-turn in policy over the past 12 months, going from raising rates in a lock-step quarterly patten to cutting them almost haphazardly. Signals from the US central bank have the markets pricing in addtional rate cuts in September through December 2019. When the Fed cuts, longer-term interest rates tend to fall and, f the markets believe the Fed is not cutting rates fast enough to avoid recession, long-term rates tend to fall faster than short-term rates, and the yield curve inverts. Most maturities are currently inverted, meaning that shorter-term bonds yield more than longer-term bonds 3. FOREIGN INFLUENCE Yields on overseas bonds-particularly German bunds, Japanese Govermment Bonds, and UK Gits-have an influence on Treasuries. Bund yields in particular have been on an incredble run, going from about 000 % at the end of April to -071% today Intraday trading action suggests buying in bonds has been leading buying in Treasuries quite consistently throughout this period. One common misconception is that Treasuries look attractive to Euro-based investors owing to their higher nominal yields (153 % vs -071% in the 10-year maturity) The reality, howevet, is that currency hedging costs more than eat up this differential and the inverted shape of the U.S. yield curve actually makes Treasuries unattractive to Euro-, Yen-, and Pound sterling-based investors. 4. MARKET PLUMBING The confluence of many factors-tighter bank capital and liquidity regulations, heavy Treasury issuance to fund budget deficits, the inverted yield curve, and currency hedging costs-are creating problems in financial market plumbing. Plumbing refers to the flow of liquidty (money) on a short-term basis. Understanding how these flows work requires a high degree of financial system knowledge, and the complexities have been grown of late. Understanding these complexities is also how we reached the conclusion that the Fed's balance sheet reduction would end early, Complex systems foil in complex ways IN CONCLUSION: Just as higher yields fed back into the financial markets and economic outlook 10 months ago, lower yields and a flatter yield curve are doing the same. Historically. falling yields coupled with an inverted yield curve has been a good predictor of recession (although a poor predictor of recession timing) Essentially, an inverted curve signals that the Federal Reserve is very likely to cut interest rates in the future. and the Fed typically cuts when there is an imminent economic slowdown. Markes aiready knew of a high probability of rate cuts, thanks to Fed commentary, so the inversion just doubles-down on that expectation. While funding costs for the corporate sector have come down somewhat, uncertainty created by global growth risks and a highly uncertain trade policy cutiook have limited the pass-through effects of lower interest rates into the real economy. Moreover, the rapidity of the yield decline appears to be creating incremental uncertainty, as the business community is womied the bond markets "know something" about the economic outlook The one positive exception to the transmission of Fed easing into the economy is, perhaps, lower mortgage rates, which should support housing sales short term and free up consumer income via refinancings Regular readers will recognize that we called for "peak interest rates" in late 2018 and came into 2019 modestly bulsh on the bond markets. with the caveat that, if we were wrong, it was because rates would fall below our forecast That caveat was borne out, although the recent rapid decine means that yields are below even the downside range of our forecasts. As Nobel laureate Paul Samuelson-oten errantly attributed to Keynes-once said, "When events change, I change my mind. What do you do?" Events are changing very rapidly. Fed action and market plumbing problems mean that overnight interest rates now have a chance of revisiting the zero lower bound as early as 2020, and long-term interest rates have a chance of pushing through their contemporary era lows. For the 10-year note, that would mean yields below the 136% reached in July 2016, shortly after the 2016 Brexit referendum After all, we are trading less than 025 % above that level today In conclusion, the recent downdraft in yields is reflective of a number of factors: A souring global economic outlook, a high probability of further Fed rate cuts, faling yields abroad, and risks to the market plumbing Implications for the economic outlook from falling yields and a fiatter yield curve are not favorable, as yield curve inversions frequently precede recessions. Finaly, it is worth pointing out that yields have fallen wel in advance of any large negative trends emerging in US. economic data. If those contemporaneous data do turn negative, we will almost certainly return to the record low yields reached in 2016, but the situation remains fluid Th pordu tyeay vesment Sagy Grouo e vedectu groperty of Jaey Mongomey Sonucuaeandayobe eoroduced d or puokshed by any person tor anygugose wt Jaeys eess nwn cosent The neportis to be sedt oioal ouses only in no event shou ebe coned s solcon or ser to uche or set a security The itamton peesene heess o sources beteed berele tut net gateed Oy Janeys to acuracy or oneeness Aey se nmet o es meroned ae ed for ue purposes on and ma not represet the spectic res or securtes wale at a en e himny of See finsl Oficial Staements orhopect for any new umetioned heren are a uet the w of nd nce o invetnents ny vary becae of changes in m ig echenge s securites prins maet ndeen we n centional or nc conons of us or ner tos Ptpeoce snotecessyde are petomance For investment adwce spectic o your stuon oror addsonomon on s o e toics, please coct your Jaey FAano your tas eg ov THE STIRLING GROUP The Stiling Group was founded on a simple belief that everyone's economic and life situation is unique. We keep that simple principle at the forefront when creating tailored financial plans for our clients. As veteran Financial Advisors, we have vast experience researching the marketplace and advising our clients on the products and services that best meet their needs. We are dedicated to learning about your personal goals, and together we will use that information to build a solid financial plan focused on your specific needs. atJa Montgonny S LLC Janney THE STIRLING GROUP AT JANNEY MONTGOMERY SCOTT LLC 2200 Georgetown Drive, Suite 400, Sewickley, PA 15143 www.TheStirlingGroupAdvisors.com 724.934.2953 in JANNEY MONTGOMERY SCOTT LC MEMBER NYSE, FINRA SPC www.ANNEY.COM