Doug Drabik, Senior Strategist, Fixed Income, and Nick Goetze, Managing Director, Fixed Income Services, assess the state of the U.S. yield curve.
To read the full article, see the full Investment Strategy Quarterly publication linked below.
As the Federal Reserve (Fed) continues to raise short-term interest rates, the U.S. yield curve has continued to flatten. This has prompted investors to question whether the yield curve will become inverted (a scenario in which short-term interest rates become higher than long-term interest rates) and what impact it will have upon the U.S. economy.
Record low interest rates can distort perceptions when assessing yields and fixed income in general. On July 8, 2016, the yield on the 10-year Treasury note closed at its three year low of 1.36%. The yield on the 10-year Treasury has since climbed to 3.07% at the time of this writing. On a relative basis, this constitutes a rise of over 126% when compared to its yield in July 2016.
While this rise certainly appears large, it is important to keep it in context; on a nominal basis, the yield on the 10-year Treasury has only risen 1.78 percentage points, or 178 basis points (bp). Over the past 50 years, the average yield on the 10-year Treasury has been 6.37%. It is worth noting that yields were skewed substantially higher during the first 25 years of that period as the Fed tried to tame high inflation. On the other hand, yields over the past 15 years have been skewed substantially lower as the Fed tried to spur economic growth following the financial crisis of 2008.
Parts of a normal economic cycle include expansions and recessions. An inverted curve signifies that shorter-term rates are higher than longer-term rates. In recent history, inversions have preceded recessions. Historically, equity markets have peaked after the start of an inverted curve. The prospect of a looming recession can incentivize investors to buy bonds with longer maturities as a safe-haven trade in the face of falling equities and/or as a method of preserving capital, potentially causing a fall in long-term yields. Since bond prices rise as yields fall, falling fixed income yields often lead to total return gains. This inverse correlation allows high-quality fixed income to potentially act as a balance to growth assets, such as equities.
It is important to keep in perspective that, on average, periods of economic expansion have been much longer than periods of recession, and positively sloped curves persist much longer than inverted curves. As a result, attempting to ‘time the market’ based on the shape of the yield curve is an extremely difficult technique for fixed income investors focused on total return. Since long-term planning is typically the norm, it is more of a distraction for fixed income investors seeking income and portfolio preservation strategies.
The Fed attempts to keep the markets stable by staving off economic instability caused by inflation or deflation. At the risk of invoking the phrase ‘this time is different,’ one of the more dangerous mantras of our industry, this time just may be different to a certain degree. Unlike the last three periods of previous rate hikes by the Fed, this time the hikes began after over seven years of interest rates at 0%. As a result, the Fed may be less focused on an overheated market and more focused on reaching ‘neutral’ interest rates after a period of unusually low rates.
A 3.00% federal funds rate is widely viewed to be ‘neutral’ by policymakers. This would entail another four or five rate hikes of 25 bp each. The Fed raised rates in September and a December hike is looming. These hikes alone could induce the yield curve to invert.
Some Federal Reserve presidents have stated that their greatest concern is inflation, not necessarily the shape of the yield curve. They are more worried about high inflation than low inflation. These statements remind us that the Fed’s mandate is to create a stable monetary environment. Given that this mandate will continue to take precedence over the shape of the yield curve, continued rate hikes increase the possibility of an inverted curve and, with it, concerns of a recession.
There are currently more headwinds than tailwinds for intermediate to long-term interest rates. As a result, they are likely to be range bound. We anticipate the yield on the 10-year Treasury to remain range bound between 2.80% and 3.40%. Given that the economy continues to show solid growth, there is reason to believe the Fed will continue its gradual pace of hikes and that intermediate and long-term rates will not keep pace, thus causing a yield curve inversion. With U.S. fundamentals still relatively strong, the reaction of the market will dictate where we head from there.
When creating a fixed income strategy/allocation, investors would do well to focus on long-term planning rather than attempting to predict future rates. A common response to a flatter yield curve is to invest in bonds with shorter maturities. However, an inverted curve does not necessarily mean that short maturity bonds are optimal. For example, on July 3, 2000, the 2-year Treasury yield of 6.29% was higher than the 10-year Treasury yield of 5.99%. However, after maturity on July 3, 2002, the funds from the 2-year Treasury would need to be reinvested. Here, investors faced a much different rate environment. By that time, the yield on the 2-year Treasury had fallen to 2.79% and the yield on the 10-year had fallen to 4.76%.
Investing in fixed income requires a different approach than investing in growth assets. Fixed income allocations are typically not designated as total return assets, which should remove the motivation to time the market for most investors. Disciplined, long-term planning can combat unpredictable market forces. Short-term thinking would lead an investor to buy short-term maturities when the yield curve is flat. However, hindsight shows that buying short maturity bonds turned out to be a less attractive investment, as confirmed by our previous example. Years of general interest rate decline have dropped rates to near historic lows, making it reasonable to presume that interest rates may continue their recent mild upswing.
While it is nearly impossible to accurately predict interest rate direction and reliably time the market, promoting a more engineered fixed income strategy (such as laddered maturities/duration) may mitigate interest rate risk, optimize return, and create structured reinvestment. Fixed income allocations may create a better hedge to heavily weighted growth allocations (such as equities) with modestly higher duration bonds. Regardless of yield curve shape, asset allocation is crucial. Due to the fact that allocations to equities and fixed income depend largely on individual needs and goals, investing in fixed income assets requires disciplined, long-term planning.
All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Fixed income investments may involve market risk if sold prior to maturity, credit risk and interest rate risk. Asset allocation does not ensure a profit or protect against a loss. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities.