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The Rate Debate

The Federal Open Market Committee (FOMC) completes a two day meeting and announces their decision on rate policy today at 2:00 PM. The overwhelming consensus is that they will cut rates by 0.25% (25 basis points) to a range of 2.00% to 2.25%. This would be the first such rate cut in over 10 years and will add fuel to a very mature growth cycle.

Some economists are even predicting a 50bp cut in the rate or words in the written statement that further cuts are baked into the next meeting for September. There is a good reason why they are calling for such urgent action. The current yield curve has an inverted rate structure going out from the 6-month bill (2.10%) to well past the 10-year bond (2.06%). This means that investors who lend money to the US Treasury for shorter periods of time are paid at a higher rate than investors who loan for a longer rate - up to a point. Getting paid less for more risk does not make economic sense and the historical data suggests that when the yield curve is inverted that there is an elevated likelihood of a pause in the growth cycle (namely, a recession) within the next 12-18 months.

As seen by the attached chart, the current yield curve is dramatically different in shape from the "healthy" upward slope shown by rates on 2011-02-18. The yield curve from 2006-03-19 sparked the early warning signs of the collapse that unraveled in 2008. A 25bp cut to the policy rate today would help to bring order back into the lending markets, but more help could be warranted in the near future to push the current economic expansion into "extra innings."

Stay tuned!

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