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