March Madness! Yield Curve Inverts and the Fed Throws in the Towel

by | BiggerPockets.com

Something major happened this week in the world of finance. The Federal Reserve has essentially given up on raising the fed funds rate any further in 2019.

This is a very “dovish” move by the Fed, signaling easy monetary policy in the future. While markets may view this as a positive in the short term, investors should be wary.

After a decade of the easiest monetary policy in the history of mankind, the Fed has found it difficult to raise interest rates as planned. It has tried to signal more aggressive rate increases, only to walk back the increases when the time comes.

Economic Indicators to Watch

As early as last fall, the plan was to raise rates four times in 2019. Now they are signaling no increases. The bond market looks like it is pricing in a cut!

Then, on Friday, March 22, the yield curve inverted. This means that the yield on the three-month treasury was higher than the 10-year treasury. This is a sign that investors are becoming very risk-averse. They believe the prospect for generating strong returns on longer term investments is weak.

It would be extremely rare for the yield curve to invert without a recession following within a couple years. Why is this important?

When the economy is in the early stages of expansion, low interest rates and easy money are a boon to investors. Financial markets, including stocks, bonds, and real estate, benefit immensely from artificially low interest rates and money creation pumped into the financial sector.

At this stage of the game, however, the economy is showing early signs of weakness. The housing market is slowing down. The Fed signaling a reversal in policy can be interpreted to mean that they think the economy and financial markets are too weak to support any more rate increases.

I’m afraid this is like when my gorgeous wife called me into the bedroom… to tell me that she spent this week’s golfing money on new shoes for the kids.

Markets may get excited, only to be let down by reality.

Keep in mind that the Fed’s “rate hikes” thus far have not even gotten back to what would historically be considered low rates.

Related: 6 Rules for Investing in Real Estate in the Coming Economic Shift with J Scott

In addition, the current rate is still below what would previously be considered recessionary rates. In prior expansions, that fed funds rate would reach double the current levels!

But the Fed throwing in the towel at this point says that the recovery might be over, and we should start thinking about how to protect our investments in the event of a downturn.

Before I get crushed in the comments, I am not calling for a vicious crash of epic proportions—although it’s always a possibility.

I am not advocating for buying land in Montana and stocking up on non-perishable goods. What I am saying is that this type of behavior at this stage in the cycle mimics other points in history where the economy started to turn.

Recessions typically play out over a multiyear tipping period before things get bad. Often, we’ve already been in a recession for a few months before economists even realize it.

I do think that buying the wrong deal with too much leverage can be papered over with low interest rates and a rising tide that lifts all boats. Try that now, and it’s going to hurt worse than stepping on a LEGO at 2 a.m. on the way to the kitchen.

Let’s take a look at what’s going on with housing, and think about what might happen moving forward.

State of the Housing Market

New home pricing was flat for most of 2018 before builders aggressively cut prices late in the year. Home builders don’t have the luxury of sitting on a home if they don’t get the price they like. They have to sell to generate cash flow and keep operating their business.

Once buyers stop settling for additional goodies and upgrades that don’t show up as price cuts, builders have to slash. That is what looks to be happening now.

Existing homes are also sitting on the market longer, while sales volume is declining pretty rapidly.

Related: This Could Devastate Your Real Estate Investing Business

Real Estate Market Predictions

Let me pull out my crystal ball for a moment.

I think a short-term rally will occur as the market’s Pavlovian response to easy policy takes hold. Cap rates may compress further as capital chases the lower financing costs.

Longer term, I believe markets will adjust. Interest rates will head back to zero as investors flee to safety. Cap rates will trend upward while stocks decline on the order of 50 percent—give or take.

Single family home prices will start to come down, albeit in a more orderly and tame fashion. It won’t be like last time, because lending practices are less ridiculous this time around.

Good deals will start to present themselves as the highly leveraged, marginal real estate players get exposed. I’ll buy great deals at high cap rates—probably from syndicators that were accountants or janitors six months ago and can’t refinance their debt.

Then, I’m going to get a boat. And the Bears are going to win the Super Bowl!

Also, Matt Nagy will ask me to be best friends, and we’ll do karate in the garage. They’ll eventually build a statue of me and “Nags” outside Soldier Field.

OK, too far. But seriously, no one has a crystal ball.

We only have two choices:

  1. Keep calm and carry on. Look for the right deals. Use lower leverage. Sell marginal deals. Raise some cash, so you can take advantage of a down market.
  2. Make a hat out of tinfoil. Buy 100 acres in northern Wisconsin. Do bug-out drills and practice eating worms.

I think I know which option I’ll choose. See you in the woods!

What are your short-term predictions? Long-term? 

I’d love to read them in the comments below. 

About Author

Phil McAlister

Phil McAlister is a Chicago-area native and real estate investor. Working for a large national sponsor, Phil has been in charge of the underwriting, financial modeling, and valuation of over $3 billion in commercial real estate, including multifamily, medical office, self-storage, hospitality, and senior housing assets. Phil leads a team in evaluating commercial real estate deals nationwide and across multiple strategies including core, core-plus and value-add, with an occasional ground-up development sprinkled in. Phil is also involved in evaluating and negotiating multi-million dollar joint ventures with various strategic partners. In addition, Phil has been tasked with evaluating projects in Qualified Opportunity Zones, a new and exciting frontier in commercial real estate.

33 Comments

  1. Christopher Smith

    I guess every article needs a little hype to grab an audience.

    Rates have been trending upward for sometime now (ZIRP is long gone, at least in the US), and the yield curve is essentially flat not really inverted in any meaningful sense. The Fed just way overplayed its hand this time, and the markets reacted accordingly, and probably appropriately.

    While ZIRP is highly problematic long term, so is needlessly throwing the global economy into a recession with what would be unnecessary rate hikes. Additionally, referring to historical interest rates is probably pretty much a meaningless comparison (other than to do a little good old fashion fear mongering), there is a new norm and whatever that ends up being I don’t think it will look anything like “historical rates” as has been referenced.

    I think targeted long term rates in the 3 to 4 percent range is fine, and we are not that far from them now even after the latest round of Fed News and global cooling concerns. Much higher or much lower interest rates and it causes systemic problems, both here and in other parts of the world.

  2. Bill F.

    Ignoring the fact that I disagree with most of this articles talking points for a host of reasons, +1 for “I’ll buy great deals at high cap rates—probably from syndicators that were accountants or janitors six months ago and can’t refinance their debt.”
    I just listened to a podcast where a syndicator described how he got into the space. He said something to the effect of, ‘I bought an SFR with the idea of BRRRing it, but it ended up not needing any reno so I couldn’t get my money out. I wanted to keep investing so I started to look into raising money for Multi Family with some partners.’ Even scarier than that last phrase is the fact he raised funds; he had no experience besides a BRRR turned BR…

  3. Steven Sansone

    The inverted curve is eye-catching for sure. Not an absolute guarantee of a recession, but definitely concerning to see. Interest rates have been more influenced by monetary policy of central banks across the globe, which may have more to do with the inversion than classic market sentiment. Some believe that there are too many other underlying economic indicators that are still strong, thus still no warrant for recession concerns. Also, the Fed was in essence raising rates just so it could lower them again when a recession inevitably hit. It’s their strongest weapon for battling declining economic activity, and they don’t want to lose it. As Dr. Jim Rickards said (of the Fed raising rates), “It’s like hitting yourself in the head with a hammer because it feels good when you stop.”

    Informative article. I appreciate your insight on how the recent housing market trends. It definitely weighs in on the ongoing discussion of whether you should still jump in to REI or sit on the sidelines until you can take advantage of a market downturn (which, for what its worth, I’m still torn).

    • Vaughn K.

      “It’s like hitting yourself in the head with a hammer because it feels good when you stop.”

      I’d say using morphine is a better example… If you are always on morphine, you don’t get the intended effect when you actually need it. Low interest rates encourage poor investments, like investing in ultra low cap rate real estate, or other marginal deals that REALLY shouldn’t be getting done. So you jack it up so people invest more prudently. When thinks tank you can temporarily juice things by lowering them, but you don’t want to stay there. The fact that the Fed was too cowardly to risk a small and minor recession between 08 and now is exactly WHY we’re going to have to have a beast of a recession sooner or later.

  4. Tom Burns

    Well-written. Who knows if it is going to be Armageddon, but life is waves and we are headed for some pull-back. I also have to give a big golf clap for my favorite comment: “I’ll buy great deals at high cap rates—probably from syndicators that were accountants or janitors six months ago and can’t refinance their debt.” I just had the same conversation with the same avatar last week. They had been in real estate for two years. I tried to inject some perspective, but got shut down. At least I know where to look when the tide shifts.

  5. Colin March

    Couple of nit-picky comments:
    –Capital doesn’t chase lower financing costs, it chases yield
    –Investors fleeing to safety didn’t cause zero % rates–it was the fed that dictated that. Flight to safety can generally be seen down the curve, let’s say the 10 year. That was never zero.
    –Saying that rates go to zero and cap rates widen probably needs some explanation. You think this will happen because banks will tighten credit standards or because investors will stop buying multi-family properties?
    –Stocks will fall 50% in the long term? Possibly, but that is a pretty lazy statement you just threw in to the post. Corporate earnings will crash in the long term? Investors will expect a much higher yield and lower PE ratios? Stock market crashes of 50% are incredibly rate and are short term in nature. Kind of weird to predict a long term market crash of 50%.

    • Phil McAlister

      Yield increases with lower capital costs, so we’re saying the same thing.

      The Fed sets the fed funds rate and buys bonds at the short end of the curve, yes. But investor flight to safety plays a part across the curve, without a doubt.

      Stocks could fall 50% and still not be considered under valued by the most reliable valuation metrics. How lazy of you not to realize that!

      I hope you read this as a fun, sarcastic blog post and not an economic white paper.

      • Vaughn K.

        There’s a reason Buffett is sitting on tons of cash… As are many other major companies… It’s because the stock market, and indeed many private businesses and other investments, are all overvalued right now. Largely because of artificially low interest rates. Lower carrying costs pushes up nominal values, this is not a new thing!

        • Phil McAlister

          Incorrect. You’re thinking about bond yields. The yield on a real estate investment (remember the original post about cap rates) will be higher, all else equal, with lower debt costs.

  6. Chris Taylor

    Just a question from an inexperienced person. Does your article apply to buy and hold rental investors? I ask because if that is your niche wouldn’t it be better to use leverage and keep capital on hand for a down turn when credit tightens? Perhaps this article applies more to investors who buy and sell versus buy and hold. Even in a down turn … renters gonna rent.

    Go Browns! #dawgpound
    ? everyone can dream!

  7. Vaughn K.

    Honestly, until the last little bit here I was feeling like an idiot for not jumping into some more stuff… But the last year plus I’ve largely decided to hold off, because all signs point towards a recession, or at least a respectable cooling off in RE in the markets I’m looking to buy in. So I’ve been sitting and waiting. So far things have been more or less consistently dropping, and I’m just waiting to see how far they go at this point! I’ve more or less got my fingers crossed hoping for an outright bubble bursting in my neck of the woods, so we’ll see!

  8. NA Henson

    I believe the yield curve inversion occurred on Thursday March 21, 2019, and the Smart Money pulled out of Wall Street on Friday, March 22.
    1. Housing starts have been trending down. In January 2109 the FRED data showed this to be true.
    2. Jobs or unemployment rate hit bottom and is trending up.
    3. Yield Curve inversion occurred March 21, 2019.

    Every recession in past 80 years was proceeded by these three events. Yes, everyone. When? 6-18 months after the yield curve inversion and the other two data sets occurred.

    My data scientist colleague presented these facts in January at an REI weekly event and he presented again last week as data for two months since January have confirmed the first two data sets trends. Housing starts are trending down, unemployment is trending up. This data mining scientist has no idea when the next recession will occur but 6-18 months from March 21, 2019. He believes next year around the election. Other experts state no recession has ever happened in an election year so we shall see who is correct. He stated clearly he does not believe it will be as severe as 2007/2008. He also stated our area of US (central Texas) is robust and different areas of the country will be affected differently.

  9. Devin Eilers

    This is pretty click baity. March madness and inverted yield curve in the title… The yield curve might have inverted looking at the 3 month and the 10 year but that is not what the reasearch is written about. The paper about yield curve inversion written by Harvey in 1986 specifically looked at comparing the 90 day and 5 year notes. Also their quarterly averages need to be inverted. Not one or 2 days.

    When the 90 day and 5 year notes invert on average for a quarter then this give a lead time of 4 to 6 quarters before a recession starts.

    If anyone has seen other studies on this I would love to see them but this is the only research that I have seen. There are lots of articles on the subject. Just google yield curve inversion and you will see all the articles mischaracterizing what the study is actually saying.

    • Phil McAlister

      I feel like I could have a lot of fun writing a post about where to “bug out” to during the coming zombie apocalypse. But, I don’t know if I want to deal with all of the comments disagreeing with my prediction of the flesh eating un-dead descending on humanity!

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