In today's investment environment, the inverted yield curve presents unique challenges and opportunities for investors.

With interest rates for short-term investments surpassing those of long-term bonds, it’s an opportune time to reconsider the strategic role of cash and bonds in a diversified portfolio.

Cash investments such as money markets and certificates of deposit (CDs) can offer significant benefits in terms of safety, liquidity, and tactical flexibility.

The Role of Cash in a Diversified Portfolio

Diversification is the cornerstone of sound investment strategy, spreading risk across various asset classes to achieve more stable returns.

While equities and bonds are commonly discussed, cash also plays a crucial role in enhancing a portfolio's resilience. Cash investments provide a buffer against market volatility, offering a secure and liquid foundation that can stabilize overall returns during uncertain times.

Benefits of Holding Cash Investments:

Safety: In times of market turbulence, cash is a safe haven.

Unlike stocks and bonds, cash investments are not subject to market fluctuations, protecting your principal investment. This makes cash an essential component for preserving wealth, particularly for retirees and conservative investors.

Liquidity: Cash provides unparalleled liquidity, allowing you to access funds quickly without incurring significant transaction costs or penalties.

This liquidity is invaluable for meeting unexpected expenses or taking advantage of sudden investment opportunities.

Tactical Opportunities: Holding cash enables you to act aggressively on tactical opportunities.

Whether it's buying undervalued stocks during a market dip or reallocating funds to more promising investments, having liquid assets on hand ensures you can capitalize on favorable conditions without delay.

Understanding the Inverted Yield Curve and Its Impact on Investment Strategy

Historically, cash investments have offered minimal returns, often trailing behind inflation. Historically over the 1928 to 2023 period, 3 3-month T-bills have yielded, on average, 3.34% while the yield on 10-year US Treasuries has averaged 4.86%. However, the current inverted yield curve has changed the landscape.

Today, money markets and CDs can yield 4-5%, making them more attractive than they have been in years. For example, the iShares Short Treasury Bond ETF is currently sporting a 5.12% yield. In contrast, the current yield on the iShares 7-10 Year Treasury Bond ETF is 4.4%. Advantage Cash!

What is an Inverted Yield Curve?

A yield curve is a graphical representation that shows the relationship between interest rates and the maturity dates of debt securities, typically government bonds.

Normally, the yield curve slopes upwards, indicating that longer-term bonds have higher yields compared to short-term bonds.

This upward slope occurs because investors demand higher returns for locking in their money for a longer period, compensating for risks such as inflation and uncertainty over time.

An inverted yield curve occurs when this normal relationship is flipped upside down. 

In this scenario, short-term interest rates are higher than long-term rates. The curve slopes downwards, suggesting that investors expect future interest rates to decline, possibly due to economic slowdown or recession.

Where are we today?

• The US Treasury yield curve remains negatively sloped with rates on the short end higher than those on the long end.

• Rates on short maturities (less than 2 years) have remained fairly close to where they were a year ago.

• However, intermediate and long maturity rates have risen from year-ago levels. For example, the 10-year Treasury has gone from 3.67% to 4.50%.

• The rise in intermediate to long maturity rates has resulted in capital losses to bondholders. Using the US Aggregate Index ETF (AGG) as a representative benchmark for the US fixed-income market would have resulted in a year-to-date loss of 1.64%.

How did we get here?

The Federal Reserve began its current cycle of interest rate hikes in March 2022, when it raised the federal funds rate by 0.25 percentage points from near-zero levels.

As of June 2024, the Fed has implemented a total of 10 rate hikes, bringing the federal funds rate to a range of 5.25% to 5.5%.

The Federal Reserve's primary tool for influencing interest rates is the adjustment of the federal funds rate, which is the interest rate at which banks lend reserve balances to each other overnight.

By raising or lowering this rate, the Fed can directly influence short-term interest rates, such as those on Treasury bills, money market instruments, and adjustable-rate mortgages.

However, the Fed has less direct control over long-term interest rates, such as those on 10-year and 30-year Treasury bonds.

These long-term rates are influenced by a variety of factors, including market expectations about future inflation and economic growth, as well as the supply and demand for longer-term bonds.

The graph below depicts the difference in interest rates between the 10-year US Treasury and the 90-day Tbill. Normally this spread is positive and upward-sloping by maturity.

After the Federal Reserve started raising rates in March 2022 it took a while but by mid-November of that year, the yield on the 10-year Treasury was lower than that of the 90-day Tbill. Since then the gap in rates has remained negative indicating an inverted yield curve.

If and when the Federal Reserve starts cutting rates (hopefully at least once in 2024) we would expect the gap to narrow eventually resulting in an upward sloping yield curve once again. As of the end of May, the 10-year Treasury is yielding 4.5% while the 3-month Tbill is yielding 5.39%.

What Causes an Inverted Yield Curve?

Several factors can contribute to an inverted yield curve:

Economic Uncertainty: Investors may flock to long-term bonds for safety during times of economic uncertainty, driving their yields down. This also applies to foreign monetary authorities looking for the safety of US Treasuries. In recent decades both Japan and China have become major buyers of US Treasuries acting as a depressant over long-term rates.

Monetary Policy: Central banks, like the Federal Reserve, might raise short-term interest rates to control inflation, leading to higher short-term yields relative to long-term rates. Monetary policy is the main reason for today’s inverted yield curve in the US.

Market Sentiment: A widespread belief that economic growth will slow can cause long-term yields to fall as investors seek the safety of longer-term securities.

Why an Inverted Yield Curve Creates a Challenging Investment Environment

An inverted yield curve can present several challenges for investors.

• Lower Long-term Returns: Long-term investments typically offer higher yields to compensate for the risk of holding an asset for an extended period. When the yield curve inverts, long-term yields fall below short-term yields, reducing the attractiveness of long-term bonds and potentially lowering overall portfolio returns.

• Economic Slowdown Signals: Historically, an inverted yield curve has been a reliable predictor of economic recessions. Investors interpreting this signal might expect lower corporate profits, higher unemployment rates, and overall economic contraction. This expectation can lead to more cautious investment strategies and a flight to safer assets, such as cash or short-term securities.

• Investment Strategy Adjustments: Traditional investment strategies may need to be adjusted in an environment with an inverted yield curve. Investors might shift from long-term bonds to short-term, high-yielding assets like money markets and CDs to take advantage of better returns. This shift can impact portfolio construction and require a reassessment of risk and return profiles.

By understanding the implications of an inverted yield curve, investors can make more informed decisions about their portfolios.

In the current high-yield environment for short-term investments, allocating a portion of your portfolio to cash investments like money markets and CDs can provide stability, liquidity, and attractive returns, helping to navigate the challenges presented by an inverted yield curve.

Actionable Strategies for Allocating to Cash Investments

Allocating a portion of your portfolio to cash investments requires a balanced approach. Here are some reasons for increasing your cash allocation relative to your typical bond holdings:

Principal Protection: Bond strategies give you an upside in the case of a fall in interest rates, but they also result in losses when interest rates rise. In the current environment, the Federal Reserve appears reluctant to cut rates. If yields drop 0.5%, an investment in, say, the US Aggregate Index (AGG) should increase by close to 3%, but if the opposite is true and rates increase by 0.5%, you’ll be starring at 3% losses. With cash investments the principal is safe.

Opportunistic Investments: Keep a portion of your portfolio in cash to take advantage of market opportunities. This might include buying assets during a market correction or funding a new investment venture.

Yield Optimization: Choose high-yielding cash investments to maximize returns without compromising safety.

Recommended ETFs for Cash Investments

Investing in ETFs that focus on cash and short-term bonds can be an effective way to maintain liquidity and safety while earning attractive yields. I consider money markets superior to bank CDs due to their liquidity.

Here are some recommended ETFs, along with information on their yields and fees:

Overview: Tracks U.S. Treasury bonds with maturities of one year or less, offering high liquidity and safety.

Overview: Focuses on U.S. Treasury bills with maturities between 1 and 3 months, providing ultra-short duration and minimal risk.

Overview: Invests in U.S. Treasury floating rate bonds, which adjust their interest payments with changes in interest rates, offering protection against rising rates.

Overview: Tracks U.S. Treasury securities with maturities of less than one year, ensuring high liquidity and security.

Overview: A diversified portfolio of short-term, high-quality fixed-income securities, aiming to provide a high level of current income with low interest rate risk.

Note: All these yields are as of the end of May 2024 and represent the SEC 30-Day Yield.

The Big Picture:

• Investors experienced moderate gains over the last 5 trading days.

• US Large Cap Equities were up 0.2% while small caps returned 1.1%.

• International equity markets experienced a down week with EM Market equities suffering a 3.8% loss for the period.

• The big winners last week were Real Estate investors -nothing dramatic and most likely a reaction to previous losses.

• Year to date US Large Cap Equities and Commodities are the best-performing asset classes.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

Economy:

• The US economy continues to be whipsawed by changing growth and inflationary expectations.

• An issue that is getting some press is the US fiscal deficit. The US has been running large deficits for a long time and in recent years the US debt has exploded.

• Since 2001 US government borrowing has averaged 6.2% of annual GDP.

• Two periods stand out - The Financial Crisis (2009) at 13.2% of GDP and the COVID-19 era (2020/2021) at 13.9% and 11.1% of GDP. Both times the US government was forced to borrow massive amounts of money.

• The IMF projects US Government borrowing of 6.5% of GDP in 2024.

• On a cumulative basis, the US Government debt is expected to stand at 123% of GDP by the end of 2024. This is higher than most developing countries and third globally behind only Japan and Italy.

• The US government debt has risen dramatically since 2001. In 2001 the US debt represented 53% of GDP. The first year where the debt exceeded 100% of GDP was 2012. Since then it’s been a steady upward path in indebtedness.

• Uncle Sam needs to either raise more revenue or cut expenses. Neither option is of great interest to Congress. Expect more of the same. As long as the US dollar remains the global currency of choice things will be fine, but the burden of paying the interest on the debt is already crowding out necessary social and infrastructure programs.

Equities:

• US Large Cap equities were up 0.2% last week with the Russell 2000, our preferred Small Cap Index, returning down 1.1%.

• International stocks had a down week with Developed Markets losing 0.3% and Emerging Markets down 3.8%.

• In terms of sectors, Tech, Industrials, and Health Care had negative returns last week. Value-oriented sectors such as Energy, Real Estate, and Utilities outperformed.

• The Momentum trade dominated by tech stocks took a back seat last week but remains the dominant style of the year.

• On the international front, the picture was mixed. International stocks have, however, outperformed US stocks over the last month.

• Swiss equities rebounded but remained at the back of the pack for the year.

• The resurgence of Chinese stocks was put on hold as investors grew more concerned about the path of interest rates in the US and remained skeptical of policy measures designed to revive the moribund Chinese housing market. Chinese equities were down over 4% last week.

Bonds:

• The Federal Reserve does not seem to be in a hurry to lower rates anytime soon.

• I expect that we get one rate cut this year but market participants seem to want more. As long as this stand-off continues don’t expect bond prices to change much.

• Investors should be focused on yield as the primary source of return.

• As such, the short end of the yield curve looks more attractive than buying into long-maturity bonds.

• Credit is also more attractive than Treasuries in light of solid economic growth.

Signal Versus Noise

What’s Coming on Premium Wednesday😀 

• Asset Allocation Performance - Portfolio Implications

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this newsletter are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.