What Does an Inverted Yield Curve Mean for Your Asset Allocation?

by: , Portfolio Strategist, New York Life Investment Management; Lauren Goodwin, CFA, Economist and Multi-Asset Portfolio Strategist, New York Life Investment Management

Last week, the 10-year US Treasury yield fell, causing the 3-month vs. 10-year portion of the yield curve to invert, and the 2-year vs. 10-year portion of the curve to flatten (Figure 1).

The U.S. Treasury Yield Curve Inverted, Potentially Signaling the Next Market Recession

Source: NYLI MAS, Bloomberg, US Department of Treasury, 3/26/19.

Under normal conditions, the yield curve is positively sloped since long-term bonds tend to yield more than short-term bonds reflecting the increased risk associated with lending money over longer time horizons.

Historically, inversions mainly occurred because of Federal Reserve (Fed) policy and declining growth expectations. During last week’s policy meeting the Fed lowered forecasts for U.S. economic growth and signaled that rate hikes are on hold. This combination pushed investors away from stocks and into safer government bonds. The higher demand for long-term bonds pushed yields below 3-month rates, causing the curve to invert.

Inversion may not be as significant a factor as the markets think

Markets react to a yield curve inversion because it has preceded many past recessions. The Fed has raised interest rates nine times since 2015, pushing short-term interest rates higher. Now that the economy is stabilizing, and the Fed sees little risk of high inflation or an overheating economy, they have stopped raising rates. Following previous economic cycles, recession comes at some point after this decision. The relationship between the yield curve and recessions has prompted market participants to use yield curve inversion as a recession indicator.

However, there is no exact science as to how long that lead time will be. Historically, recessions have followed yield curve inversion anywhere from 6 to 36 months. Being too early in hedging against potentially negative news is rarely beneficial for portfolio positioning. In fact, history has shown that it can cause a portfolio to miss out on any upside potential. For instance, since the 1960s, the stock market moved higher in the one year following six of the last seven yield curve inversions (Figure 2).

The Stock Market Moved Higher in the One Year Following 6 of the Last 7 Yield Curve Inversion Periods

Source: NYLI MAS, Bloomberg, Thomson Reuters DataStream, 3/26/19. Past performance is no guarantee of future results. An investment cannot be made directly in an index.

In this instance, technical factors likely contributed to the yield curve inversion, reducing our concern that a recession is imminent. For example, the Fed’s language likely prompted a “flight to safety” response from many investors placing downward pressure on yields. A rapidly flattening yield curve also sends a signal to many technical trading algorithms, which can increase yield pressure.

Implications for the economy and our portfolios

While we carefully watch fixed-income markets and the signal that a yield curve inversion sends, we are not worried about a recession in 2019. Global economic data has been slowing, but increased monetary and fiscal support suggests that governments are targeting a reflation strategy. We believe the Fed and European Central Bank pauses, along with China’s stimulus, will put a floor on economic growth.

In the medium term, as a widespread global reflation strategy takes hold and the economic outlook improves, we should see more support for risk assets.

That said, we don’t expect the turnaround to occur immediately. So, we are bracing for a tough April. Quarter-end window dressing, and likely poor earnings reports for Q1 2019, could result in a near-term market consolidation. Mixed economic data could amplify a risk-off trade that makes any tactical risk-on positions dangerous until that consolidation has passed.

We are risk-on in our 2019 full year view for markets. However, we think the market may consolidate as initial Q1 earnings are released, giving us a more attractive entry point for adding equity risk. When we do, we favor U.S. and emerging markets equities and hold neutral positions in most of our fixed-income asset classes.

About Risk

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Asset allocation and diversification cannot assure a profit or protect against loss in a declining market.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

Definitions

The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.

1810557

Robert Serenbetz

Portfolio Strategist, New York Life Investment Management

Robert Serenbetz is the Portfolio Strategist with New York Life Investment Management’s Multi Asset Solutions (MAS) team. He contributes to investment thought leadership and communication efforts across New York Life Investment Management

Full Bio

Lauren Goodwin, CFA

Economist and Multi-Asset Portfolio Strategist, New York Life Investment Management

Lauren Goodwin, CFA is an economist and multi-asset portfolio strategist with New York Life Investment Management’s Multi Asset Solutions (MAS) team, which has $10B in assets under management. She joined NYLIM in 2018 to focus on global macroeconomic trends

Full Bio

Leave a Reply

Your e-mail address will not be published.