Bond market neuroticism
Yields are up, and with it, so too are the number and volume of the alarm bells. Two alarms are particularly loud:
- A flattening of the curve
- An upward rise in yields across all maturities
For now, we feel that these warnings are early.
Let’s tackle curve flattening first. A flat or inverted curve (when short-maturity instruments offer a higher yield than longer-dated bonds) inhibits credit growth, stalling business activity and sending the economy into recession. Few indicators have shown greater explanatory power in predicting an impending recession than has an inverted curve, so the attention it receives is well justified. But, we take issue with the attention the flattening story is currently drawing.
To begin with, we don’t see it! The spread between the two-year note and the ten-year bond is the most oft-cited segment of the curve. At year end, they were roughly 50 (bps) basis points apart. Today? Roughly 50 bps. Our expectation is that this spread will remain narrow but positive for quite some time yet, much like the late ‘90s, during which, this gentle slope was maintained for several years.
U.S. Treasury yield curve steepness (5/26/16 – 5/24/18)
Source: Thomson Reuters Datastream, New York Life Investments, as of 5/24/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
Second, it’s important to remember that even an inverted curve tends to precede an equity market correction and an economic recession by several quarters. The slope of the curve isn’t threatening a bear market anywhere on the visible horizon.
Yield curve slope returns
|One-year return on S&P|
|Between 0 and 50 bps||12.48%|
|Between 50 and 100 bps||16.81%|
|Between 100 and 200 bps||5.20%|
|More than 200 bps||10.82%|
Source: S&P 500 Total Return Index. Based on daily returns, as of 12/30/17. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
And yet, several members of the Federal Open Market Committee (FOMC) are still fretting publicly about the potential for the curve to invert, cautioning against a too-aggressive rate hike campaign.
We see an alternative course of action as a possibility. Earlier in the cycle, the Fed engaged in “Operation Twist”, in which they sold short maturity holdings and purchased long bonds in a successful effort to drive yields lower at that end of the curve. Now that they are unwinding the quantitative easing, what’s to stop them from likewise reversing Operation Twist, selling long bonds to buy short maturity debt, putting upward pressure on the slope of the curve? Nothing.
The yield on the ten-year Treasury Bond recently broke through 3.1%, achieving its highest level in seven years. The implications for equity investors are unclear:
- An argument can be made that more attractive yields will draw investment dollars away from stocks.
- There’s also the concern that higher debt costs will eat into profit margins and discourage credit growth.
At some level of yield, these fears are entirely rational, but we’re skeptical that today’s rates present much of a threat to equities.
Real rates remain quite low, neither discouraging corporate investment nor likely drawing significant risk capital away from equities. Our expectation is that bond yields will continue to rise gradually in response to rising inflation, heavy issuance resulting from the growing federal deficit, and falling demand as the Fed allows its balance sheet to unwind.
The hand-wringing among the financial press regarding shifts in the Treasury curve has been constant of late. Despite rising, yields are only moving back toward a normal state of equilibrium. We don’t, for now, view this as a viable threat to either accelerating economic growth or rising stock prices as we move into the second half of 2018.
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Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months, and pays the face value to the holder at maturity
Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
The Standard & Poor’s 500 Index (S&P 500) is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion and is seen as a leading indicator of U.S. equities and a reflection of the performance of the large-cap universe. The Standard & Poor’s 500 Index (S&P 500) is one example of a total return index. The total return indexes follow a similar pattern in which many mutual funds operate, where all resulting cash payouts are automatically reinvested back into the fund itself.
Short-term maturity instruments – An open-ended mutual fund that invests in short-term debt such as money market instruments (fixed income securities with a very short time to maturity and high credit quality).
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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