Market Review

Here are recent returns from several market indices: Note especially the difference in returns among the various indices this past month and year to date. Also, note the generally positive results over longer periods.

Stocks

Domestic stock prices were volatile throughout April. After starting the month down significantly, stocks have bounced back recently to nearly flat for the S&P 500. These ups and downs primarily reflect the whims of tariff implementation.

Year-to-date domestic stock markets were down – Large Cap (S&P 500) off 5% and Small Cap (Russell 2000) down 12%. The S&P 500 results reflect that the Magnificent Stocks continue to give back much of their past extraordinary results. Year-to-date, an equally weighted portfolio of these stocks (Amazon, Apple, Google, Meta, Microsoft, Nvidia and Tesla) shed nearly 13% of their value. On the other hand, stocks traded in International Developed markets (EAFE) earned 12% from the beginning of the year, demonstrating the benefits of commitments to this market.

While domestic stock markets have been uncomfortable recently, we can take some consolation in the numbers over longer periods. While not sustainable, the level of five- and ten-year returns in the US Large Cap market stand out.

Bonds

Bond markets are unsettled reflecting today’s uncertainties. Real interest rates shot up 0.4% at the beginning of the month. Although falling back recently, this behavior is worrisome as it’s indicative of increased risk in the market for US Treasury securities, making it more difficult, as well as costly, to finance growing deficits. The term premium (10-yr yield minus 2-yr yield) jumped to 0.5%.

Note from the accompanying Yield Curves that while remaining generally constant in April, intermediate-term bond yields are down year-to-date, resulting in positive bond returns.

Risk and Uncertainties

Markets are forward looking. As the future becomes murky, stock prices are increasingly volatile. Among the negative clouds are the implementation and economic impact of tariffs; the threat of politicizing the Fed; the impact of budget negotiations on the deficit; and an economic slowdown (recession).

Risk and uncertainty are different concepts – risk can be measured, uncertainty cannot. Risk is the possibility that the future will be different from what’s expected. This chance can be measured with probabilities and statistics. Uncertainty, on the other hand, is a description of the state of the world. Not only is this situation constantly changing, but it can’t be measured precisely.

Markets have weathered uncertain periods before. Risk profiles (average returns and standard deviation) of stock returns reflect how markets deal with uncertainty. While the events that trigger volatility are forever changing, these profiles have remained generally constant and are a reasonable description of the future.

If we look around us there are always things about which we are uncertain. Today it is tariffs. We are uncertain not only about the economic effects of tariffs, but also how future tariff regimes will unfold. Of course, it’s this uncertainty of where tariffs are going that drives market volatility, which will continue until some of the uncertainty is resolved; however, others will take their place.

Market Review

Here are the recent returns from various market indices:

Stocks

Stocks are volatile this month. Returns of the six AI companies that have driven the S&P 500 recently are not as dominant. Note in the above chart that domestic stocks are down while international stocks have picked up the slack. The returns in developed international markets (EAFE) and emerging markets (MSCI Index) stand out. While certainly not a trend, it is heartening to those who have argued for a long time that an allocation to non-domestic markets is important to a well-diversified portfolio. Diversification paid off this month and quarter.

Not only volatile, but stock returns have been more dispersed recently. Returns of the six AI firms reacted differently to the introduction of the competition from DeepSeek. While Nvidia, Microsoft, and Apple were off, Amazon, Google, and Meta were up over the same period, providing evidence of some independence among these market drivers. Recent measures of dispersion are lower for stock indices than for individual stocks in the index, which is indicative of less correlation among returns in today’s stock markets.

Bonds

With declining yields in recent periods, bond returns are up. Bond returns are evidence of a mostly stable interest rate environment. The pattern of yields across several maturities (Yield Curve) remained at its more normal upward-sloping shape.

Inflation and the Yield on 10-Year Treasuries

The yield on 10-year Treasuries reflects inflationary expectations and prospects for an economic downturn. This yield came down nearly 0.25% this month. Stripping away implied inflationary expectations, this drop in yield is consistent with an expected falloff in economic activity, as the inflation- adjusted yield was down 0.3%.

While the spread between the inflation-adjusted yield and nominal 10-yr. yields ticked up a bit, it is still a rather benign 2.4%, and inflation is becoming worrisome once again. No doubt this concern reflects cost-conscious consumers changing their food buying habits, especially fewer eggs, in response to years of rising prices and an uncertain inflationary future. Tariffs, tax cuts, and deficits add to the worry of future inflation.

The Cost of Market Timing

Serious long-term investors know it is best to avoid making changes to established strategic allocations in response to market ups and downs – yet, maintaining this discipline is hard. There will be many periods, some quite long, when one particular asset class does better, sometimes dramatically, while others do not keep up. The urge to tilt towards outperforming markets and away from those that have underperformed (market timing) is difficult to resist.

However, giving in to this urge can be costly in the long run. A simple decision model may be helpful to understand this cost: I compare a timing strategy in the S&P 500 Index consisting of forgoing the subsequent quarter’s return if the current return is below the trailing five-year average. At the end of twenty years, this strategy results in a portfolio of about one-half the size of that from doing nothing and letting the wonder of compounding do its work. While admittedly a simple decision model, adding more realistic complexity doesn’t change the conclusion – market timing rarely pays in the long run.

Market Review

Here are the recent returns from various market indices:

Market	Quarter	Year	5 years	10 Years
US Large Cap (S&P 500)	2%	25%	14%	13%
US Small Cap (Russell 2000)	0%	12%	7%	8%
Int’l Developed (EAFE)	-8%	4%	5%	5%
Emerging Markets (MSCI Index)	-8%	8%	1%	4%
Short-term Bonds (Treasury 1-3 yr)	0%	4%	1%	1%
Intermediate-term Bonds (Treasury 3-5 yr)	-2%	2%	0%	1%
Long-term Bonds (Treasury 5-7yr)	-5%	-1%	-1%	1%
Inflation (CPI)	1%	2%	4%	3%

Stocks

We have witnessed more volatility in domestic stocks lately. Stocks dropped in response to the Fed’s rate cut but have come back some since. Except for the S&P 500, it was a flat-to-down quarter, especially in international and emerging markets.

Recent periods notwithstanding, 2024 was a good year for stocks (international developed markets the exception). The S&P 500 continues to be driven by just six companies: Amazon, Apple, Google, Meta (Facebook), Microsoft, and of course Nivida, that are expected to benefit from the continued development of AI. In 2024, an equally weighted portfolio of these six companies was up 60%; Nvidia was up 177%.  The results in domestic small cap markets and emerging markets are above long-term averages. A portfolio diversified among both domestic and non-domestic markets earned 10% in 2024.

Developed international markets did not keep pace. This relative performance does not reflect earnings shortfalls but primarily how market values these earnings.

Look at how the S&P 500 stands out in all periods; this result is again driven by just the few tech companies that are expected to participate in the development of AI.

Elections triggered expectations for an improved investment landscape, which pushed stocks upward. Cryptocurrencies especially gained, but don’t pay any attention.

Bonds

The accompanying picture showing bond yields for several maturities (Yield Curve) tells the 2024 bond story – short-term bond yields falling but rising at the longer end. Consequently, returns on short-term bonds exceeded returns at the longer end.

In recent periods bonds have not contributed much to the results of a well-diversified portfolio. This will not always be the case.

The changes in bond yields over the past year have brought the Yield Curve to a more typical pattern signaling little change in rates.

Inflation

Inflation in 2024 matched the goal of 2%, which was achieved without triggering a recession and contributed to a positive stock market environment. However, inflation at 4% for the past five years meant general price levels increased 20% over the period, which is still painful.

The difference between the 5- and 10-year nominal and inflation-adjusted yields is 2.3%, which is the market’s projection of inflation over those periods. This number is little changed from the beginning of the year.

Uncertainties Ahead

Stock prices and returns are based on continuous trading by informed buyers and sellers, both of whom make decisions on their best assessment of the future. As new information comes in, prices change – either up or down. Some of today’s uncertainties include:

• A correction in domestic large cap markets. Recent S&P 500 returns are unprecedented. The enthusiasm for the future of AI in just a few tech companies has produced a nice run. A reasonable concern is that AI is oversold.
• Renewed inflation. While inflation currently seems in check, an environment of tariffs, deficits and reduced immigration could bring inflationary pressures.
• Remaining diversified to international markets has been like “waiting for Godot.” Yet, based on the evidence that markets eventually revert to long-term averages, we continue to wait for our patience to be rewarded. We’ll see.
• Political disruptions. Voters expect disruptions from the Trump Administration. The extent and economic impact of these disruptions is uncertain.

Adding to the uncertainty of these “known unknowns,” there are “unknown unknowns” as well. Predicting this uncertain future is rarely rewarded – the best approach is enduring the uncertain future by remaining diversified.

Market Review

Here’s a snapshot of recent returns for indices representing various stock and bond markets:

Market	Trailing 3 Months	Year to  Date	Trailing  12 Months	Trailing 5   Years
US Large Cap (S&P 500)	7%	21%	37%	15%
US Small Cap (Russell 2000)	4%	10%	33%	8%
Int’l Developed (EAFE)	2%	7%	22%	6%
Emerging Markets (MSCI Index)	6%	12%	25%	4%
Short-term Bonds (Treasury 1-3 yr)	0%	4%	6%	1%
Intermediate-Term Bonds (Treasury 3-5 yr)	-1%	2%	6%	0%
Long-term Bonds (Treasury 5-7 yr)	-3%	1%	8%	-1%
Inflation (CPI)	0%	2%	2%	4%

• These numbers suggest a good period for stocks. The year-to-date and trailing month periods have been especially pleasant. I think it’s the expected growth of AI as well as falling interest rates and a positive economy that help to explain these results.
• Returns of the S&P 500 stand out. This index is heavily weighted in the stocks of just six companies (Amazon, Apple, Google, Meta [Facebook], Microsoft, and Nvidia) that are expected to participate in the growth of AI. Nvidia is up an extraordinary 170% this year. Meta is up 60%.
• China makes up more than 25% of the Emerging Markets Index and reflects the recent ups and downs of that economy.
• Bond market returns are driven by changing yields. Observed returns depend on maturity – longer maturities do better when yields fall; shorter maturities do better when yields rise.
• Inflation is generally in check. The Consumer Price Index (CPI) is running close to the Fed’s 2% goal. However, what keeps inflation in the news is that a 4% inflation rate over five years means price levels have jumped more than 20%.
• We can get a hint of what’s expected for future inflation by looking at the difference between observed and inflation-adjusted yields, which is a comfortable 2.3% for 5 yr.-bonds.

Pattern of Bond Yields

The change in the pattern of yields (Yield Curve) for several maturities are shown here – notice the twists – yields at the shorter term falling and longer-term yields rising. Since returns and prices behave inversely with changing yields, these twists explain recent bond markets. Also, the Yield Curve is generally upward sloping for bonds maturing beyond two years, which is more typical.

Yields jumped over 0.5% this month, signaling increases in the cost of capital (interest rates) as inflation expectations did not move. A rising cost of capital can have a negative impact on economic growth.

A Perspective on Recent Stock Market Results

The robust stock returns of recent periods, especially in the tech-ladened S&P 500, have led some to suggest a “correction” is ahead. There is considerable uncertainty in today’s investment landscape due to our closely contested election, wars in Ukraine and the Middle East, the impact of AI, and rising interest rates. Yet today’s prices are established in a well-functioning market and reflect what is known – the future is, of course, unknown.

In a well-functioning market prices incorporate available information. Stock prices and returns are based on continuous trading by informed buyers and sellers, both of whom make decisions on their best assessment of the future. New information drives price changes as it becomes apparent, assessments of the impact are evaluated and prices change. However, the impact could be either positive or negative.

While we may experience a correction, it will be due to unpredictable surprises. Consequently, to deal with uncertainty it’s best to maintain established commitments to a well-diversified portfolio and periodically rebalance in response to future volatility.

Market Review

Stocks

In August, a globally diversified portfolio fell 5.6% in the first five days only to snap back to earning nearly 2% by month end. Domestic small cap stocks (Russell 2000) were down 1% in the month, giving back much of their July results. Other stock indices, however, ended up between 2% and 3%. These results confirm that “do nothing” was the best response to the unexplained falloff at the beginning of the month.

So far this year, stocks have rewarded investors, earning returns that range from 10% for the MSCI emerging markets index to 19% for the Tech-ladened S&P 500. These numbers clearly demonstrate “exuberance.”  However, with falling interest rates, reduced inflation, a “soft landing,” plus the prospects for AI, a case can be made that they may not be “irrational.” The trailing 12 months have been equally good for stocks with returns ranging from 15%-30%.

While the recent past has been good for stocks, there is plenty of uncertainty about what lies ahead.  Consequently, we should be cautious about extrapolating recent results very far into the future.

Bonds

In August, yields fell 0.4%, and between 0.5% and 0.7% since June 30, for bonds maturing beyond a year, reflecting an anticipated cut in the Federal Funds rate. It is widely expected that the Fed will reduce this rate at their September meeting. Bond prices move inversely with yields; consequently, bonds earned between 2% and 4% quarter-to-date depending on maturity (longer term up more).

Recent periods have been good for investors (a 60/40 stock/bond portfolio earned 16% over the trailing 12 months); yet, it continues to be appropriate to avoid making predictions while maintaining established commitments to well-diversified portfolios sufficient to span capital markets.

Dealing with Stock Price Volatility

This past month’s results, as well as the first days of September, confirm once again that stock markets are volatile. What explains changes in stock values is continuous receipt of information as well as simple noise, which means future returns are random and unpredictable.

Theoretically, the observed stock price is when traders decide to sell to traders who decide to buy. It’s information about an uncertain future that drives these decisions and, consequently, stock prices. As new information becomes available prices change. Since there is no pattern in the receipt of new information there is no predictable pattern in stock prices. Contributing further to this unpredictability are changes that can’t be explained by new information – “noise.” The falloff in early August fits the noise category.

However, if we are willing to accept that market response to uncertain events is consistent through time, then history provides a means to objectively describe an unknown future. While not a prediction, the past pattern of stock returns provides a reasonable distribution of future prices. This distribution provides an expected payoff, and a range of possible outcomes from which we can calculate a probability, which is perhaps the best we have for dealing with an unknown future.

Interest Rate Risk in Bonds

Rapidly rising interest rates explain bond market losses in recent periods. The Bloomberg U.S. Aggregate Bond Index, a reasonable proxy for the U.S. bond markets, is off 4% over the past three months, confirming that bonds are risky.

Bond risk is from two sources primarily – credit risk and interest rate risk. Credit risk is straightforward – it’s the chance that the bond won’t pay interest and principal as agreed. The premiums for bearing this risk change primarily in response to changes in the economy. Interest rate risk is the variability in bond values in response to changes in interest rates. Recent results reflect the impact of changes in interest rates (interest rate risk).

Interest rate risk is not the same for all bonds. It depends on its duration (years to maturity adjusted by the effect of periodic cash flows). We can see the impact of duration on bond returns by looking at recent results for U.S. Treasury indices. Securities issued by the U.S. Government, by definition, bear only interest rate risk. The 1-3 Year Index earned 1%, while the 3-5 Year Index lost 1%, and the 7-10 Year Index lost 5% over the past three months. It’s only if the bond is to be held to maturity and there are no coupon payments (Treasury Bill or zero-coupon bond) that it will earn the yield implied when it was purchased. Otherwise, there is interest rate risk.

Bonds are risky – the sources of this risk are complex. It is important that they are well understood.

MARKET REVIEW

Stocks

While showing some signs of coming back, stocks are down this month, which brings the trailing three months’ numbers to negative 3% for the S&P 500 and 12% for the domestic small cap index (Russell 2000). In this three-month period our international market index (EAFE) and emerging market index (MSCI Emerging Markets) are down 6% and 8%, respectively. A globally diversified stock portfolio is off 8% over this period.

Clearly, there has been a reduction in the appetite for risk. However, while the turmoil in the Middle East gives us more to worry about, the economy seems in good shape – unemployment is low, inflation is falling, rapidly increasing interest rates are mostly behind us, and we seem to have avoided a recession. Of course, it’s hard to be optimistic about inflation when the average price of items that make up the Consumer Price Index (CPI) has gone up 30% over the past three years. The outlook seems better and, as the past few days have demonstrated, it can become positive quickly.

Bonds

Over the last three months, yields on short-term Treasuries have not moved from the 5.5% range. After moving up significantly, longer-term yields fell back in just the last few days of the month to where they are just above where they were at the beginning of the month. Over the trailing three months, on the other hand, these yields have pushed up – the current 10-year yield of 4.7% is up from 4%. Since bond prices move in the opposite direction from yields, we can see the impact of these increases in the 3.5% loss in the 7–10-year Treasury index. The spread between nominal and inflation-adjusted yields, a reasonable measure of the market’s expectation for inflation, has remained at a little more than 2%.

Inflation and a “Soft Landing”

Inflation expectations and the economic impact of the Fed’s ratcheting up its Target Interest Rate has been a major source of uncertainty. So far, the trajectory of inflation has been in the right direction and unemployment has remained low. The trailing 12-month change in the Consumer Price Index (CPI) has declined from its peak of 9% in March 2022 to less than 3% this month, while unemployment has remained in the historically low 3.6% range. Equity markets have responded positively. However, this good news notwithstanding, uncertainty seems to persist.

This uncertainty reflects the conventional wisdom that increasing interest rates to fight inflation means a recession. One indicator of an impending recession is a downward sloping Yield Curve (future interest rates expected to be lower). The argument here is that the Fed will have to reduce rates to pull the economy out of a recession. However, the shape could also mean lower future inflation. Interest rates typically include a risk-free rate plus a premium for expected inflation. With inflation coming down, a reduction in that premium could explain the expectation for lower interest rates implied by the downward sloping Yield Curve.

Further confounding the usual link between rising interest rates and a recession, is the extent to which inflation is embedded or transitory. The pandemic not only produced massive deficits to offset unemployment, but it also brought on supply chain disruptions. Additionally, the invasion of Ukraine drove grain prices up. While these factors seem temporary, with the recent 0.25% increase in its Target Federal Funds rate, the Fed seems committed to drive out any embedded inflationary expectations erring on the side of an economic slowdown.

What to do in the face of these uncertainties is always the same – avoid predictions, continue to rebalance to established strategic allocations, and enjoy the ups and endure the downs 

Market Review

Stocks

Stocks up nicely this quarter with returns from 3% to over 6% for small cap value stocks. Diversification helped this quarter as markets other than the S&P 500 picked up the pace. Year-to-date, however, it’s that market (S&P 500), led by the usual Tech companies (Amazon, Apple, Facebook, Google, Microsoft and Nvidia), that turned in returns better than 20%. Nvidia, perhaps the most popular way to jump on the AI bandwagon, more than doubled since the beginning of the year. Other stock markets turned in returns nearing 10% over the year-to-date period.

Bonds

Yields were up resulting in essentially flat bond returns (price reductions offsetting coupon payments) this month. This pickup in yields is consistent with the Fed’s 0.25% increase in its Target Interest Rate.

The Yield Curve (pattern of Treasury yields across several maturities) continues to slope downward, suggesting reduced yields ahead. The jury is still out as to whether this signals a future need for the Fed to reduce rates in response to a recession or reduced inflation expectations. The market’s expectation for inflation, as evidenced by the spread between 5-year nominal and inflation adjusted bond yields, remained at just above 2%. This number is consistent with the Fed’s target and a seemingly positive implication for inflation ahead.

Stocks

Stock markets are volatile waiting for some resolution of today’s uncertainties, which include not only the Debt Ceiling, but also the banking system, the trajectory of interest rates and the Fed’s perseverance, inflation expectations and the prospect for a recession.  Monthly stock returns are mixed – Domestic stocks are little changed; international stocks are down.  The year-to-date numbers look better driven by the largest US Tech Companies and developed international markets.  The EAFE is up 7% and the S&P 500 is up nearly 10%, almost all of which is explained by Apple, Microsoft, Google, Amazon and Facebook.

Bonds

Over the past thirty days yields for shorter-term bonds were up, especially for one-month maturities.  Yields for bonds that mature beyond two years were little changed.  The shorter-term yields shot up due to the uncertainty in the resolution of the US debt ceiling negotiations.

The yield curve continues to slope downward – usually a sign of lower interest rates ahead, which is consistent with expectations for a more accommodative monetary policy to combat a recession and reduced inflation.  The spread between 5 and 10-year nominal and inflation-adjusted yields, a reasonable measure of market expectations for inflation over these periods, remains just above the Fed’s 2% objective.

Diversification

The year-to-date stock market numbers show us some of the short-term costs of maintaining a well-diversified portfolio.  Recently large company stocks traded in both domestic (S&P 500) and international (EAFE) markets, earned returns well above those of other markets making it uncomfortable to remain committed to a diversification strategy.  Yet, it is well known that diversification increases a portfolio’s expected return without assuming more risk – a “free lunch.”

Allocations to value stocks (value effect) and stocks of small companies (size effect) have been shown to produce diversification benefits.  It is reasonable to expect premiums of 1% to 1.5% but with considerable short-term variability.  This variability is especially evident in recent periods. While over the previous three years a portfolio geared to take advantage of this value and size effect has matched the returns of broad market indices, recently it has lagged by an uncomfortable 3% margin.  However, because shortfalls will not last forever and turnarounds can happen quickly, it is important to remain committed to these markets.

Monitoring Results

Monitoring results is an important role of fiduciaries. While at first glance this process seems straightforward, it is not.  Two problems loom – (1) using short-term results to monitor long-term expectations, and (2) random noise in the data. To deal with the first problem fiduciaries construct and maintain benchmarks that reflect appropriate risk profiles.  Periodic results are measured against these benchmarks and nothing else.

The second problem means that periodic results will not always match even a well-constructed benchmark – sometimes they will be above, other times below (tracking error).  Regardless of whether positive or negative, tracking errors must be investigated, and explanations understood.

Monitoring periodic results and maintaining diversification strategies can be hard, yet is key to investment success.

Stocks

After enduring ups and downs due to the uncertainty in the financial system and the Fed’s response triggered by the collapse of Silicon Valley and Signature banks, stocks ended the first quarter in positive territory. Domestic large cap stocks, International developed markets and emerging markets were up between 4% and 8%, small cap stocks and REITs up just under 3%. Over the trailing twelve months, on the other hand, except for International developed markets, stocks were down significantly because of rising interest rates and inflation uncertainty.

While the past year was not kind to stocks, the story has been mostly positive over longer periods. The past three years saw a portfolio diversified among several markets earning about 15%. Although with considerable variability among individual markets, a diversified stock portfolio earned about 4% and 7% over the last five and ten years, respectively.

Bonds

Recent turmoil in the banking system drove bond yields down, especially for longer maturities. Since prices move inversely to yields, this downward trajectory in yields pushed first quarter bond returns up between 1.5% and 2.8% depending on maturity. The Yield Curves below show the extent to which yields have climbed since March 2022. The primary culprit is the Fed increasing its Federal Funds rate to dampen inflation. While yields fell back a little this quarter, with the recent 0.25% increase in the Federal Funds rate, the Fed seems committed to keeping rates high for the immediate future.

The spread between nominal- and inflation-adjusted five- and ten-year yields, which is a reasonable measure of the market’s expectation for inflation over these periods, is close to the Fed’s inflation target. The shape of the yield curve can be a harbinger of future interest rates – today’s downward sloping shape implies reduced rates ahead. These signals are positive for future inflation.

Failure of Silicon Valley and Signature Banks

The turmoil in banking brought on by the collapse of Silicon Valley and Signature Banks has not only unsettled markets, but also increased uncertainty in the financial system associated with rapidly rising interest rates and the fight to dampen inflation. These two banks failed because after being accustomed to low interest rates, management lost track of the impact of rising interest rates on bond values. It was surprised by the prices at which its bonds had to be liquidated to meet unanticipated depositor withdrawals, causing sharp losses and eventual failure.

Further exacerbating this interest rate risk, these banks had a concentrated base of large depositors. In response, the Fed has stepped in to protect all depositors. While this intervention has lessened the impact of this crisis, the extent to which it creates a moral hazard that distorts future economic decisions is a downside.

While the implications of the failure of these two banks appear to be well-known and somewhat manageable, it brings heightened uncertainty, not only in the banking system, but also with the Fed’s continued resolve to squeeze out inflation, the availability of credit and economic activity going forward. While the market has absorbed this uncertainty reasonably well so far, we can anticipate continued market volatility.

Stocks

Stocks continued to climb in January, with small company and non-domestic stocks earning between 8% and 10% leading the way.  Domestic large cap stocks (S&P 500) returned 6% for the month somewhat less than other markets, which is a change from recent history. A globally diversified stock portfolio was up 8% for the month and 14% over the trailing quarter. International developed markets and emerging markets were up 8% this month and 19% over the trailing quarter reflecting to some extent the decline in the value of the dollar.  These recent numbers demonstrate the benefits of diversification to non-domestic markets.

Bonds

Except for an up-tick in one-month maturities, short-term bond yields did not move much in January.  Yields on longer maturing bonds (beyond two-years), on the other hand, fell a bit resulting in positive returns.  An index of U.S. Treasury securities maturing in 1 – 3 years returned 0.7% in January; the 3 – 5-year index earned 1.7%. Over the trailing 90 days, the shorter-term index posted a 1.8% return; longer-term index returned 3.6%.  These results are significantly better than what we experience the past twelve months.

Inflation as measured by changes in the Consumer Price Index was flat for the month and trailing quarter.  Over the training twelve months the change was 5.7%, well below 8.7% we saw in March 2022.  The spread between 5-year nominal and inflation-adjust yields, a reasonable measure expected inflation over the period, is 2.3% – not far from the Fed’s goal.

A “Soft Landing”?

Since January 2022 the Fed Funds rate increased from 0.25% to 4.5% reflecting the Fed’s effort to dampen inflation.  The goal is to do this without a significant economic slowdown that often accompanies interest rate hikes.  Markets are forward looking.  While surprises could be lurking, generally market signals anticipate a “soft landing” – stocks are up, bond yields look reasonable, and labor markets are robust for now.

Signals from stock markets are positive.  Last quarter and this month stock returns are up with relatively low volatility.  While these markets can change quickly, current prices do not reflect a significant downturn.

Bond market signals are mixed. Current bond yields are constant at 4.7% over the next year but decline to 3.7% at five years. This downward shape of the Yield Curve can be a predictor of recessions as it suggests a future need for the Fed to reduce interest rates to spur growth.  Yet, expected future interest rates (roughly 3%) implied by today’s pattern of yields do not anticipate a need for massive changes in monetary policy.

Current signals from the labor market are positive.  Unemployment levels and rates are about where they were prior to the Pandemic and much anecdotal evidence suggests difficulty in hiring. While the current spate of announced layoffs in large Tech companies is unsettling, labor markets do not seem poised for a sharp recession.

While there is always room for uncertainty, current signals from stock markets, bond markets and labor markets point to any future recession being reasonably mild – a “soft landing”.