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Fixed Income: What is the yield curve telling us?

05th July, 2019

Global government bonds have performed strongly since the beginning of the year. Further downgrades to global economic growth forecasts, Brexit uncertainty and concerns over a trade tariff escalation have lured investors to the safety of government bonds.

In the US, the yield curve remains flat. Historically, an inverted yield curve has been a useful indicator of recessions as investors expect interest rates to be lower in the future alongside a weakening economy. So, the recent curve flattening has been attracting the attention of investors.

What determines the shape of a yield curve?

A yield curve simply represents the interest rates on government debt at different maturities at a given point in time.

When yields of shorter dated (typically 1-2 year) government securities rise above those on the longer maturity (10 years+) securities, the curve is said to invert. The chart below (Figure 1) shows how the US Treasury yield curve has flattened over the past two years.

Shorter maturities are closely correlated to the US Federal Reserve (Fed) fund target rate - the official interest rate for the country. As a result, it is not unusual for the yield curve to flatten during an interest rate hiking cycle. Yields on longer maturity debt also reflect the central bank interest rates but are influenced to a greater extent by the outlook for the economy.

Figure 1: US Treasury yield curve across maturities (%)

Source: Bloomberg 

The predictive powers of the yield curve

Today, similar to previous cycles, many are questioning the predictive power of the yield curve, and in particular how has Quantitative Easing (QE) resulted in a distorted, lower yield environment.

Others argue that the increased issuance of shorter maturity Treasuries since 2016, to fund the growing US budget deficit, has placed upward pressure on short maturity yields. Despite the strength of these arguments, it would be foolish to completely dismiss the yield curve’s signals.

Figure 2: Basis point change in US yields by maturity (25th June 2017 - 25th June 2019)

Source: Bloomberg

How concerned should investors be about recent yield curve activity?

Many clients are asking if the recent, brief inversions of the 3-month/10-year curve is signalling an imminent recession. We do not believe so. The lengths of the recent inversions were limited, which in the historical context, looks too short to be a reliable indicator. More likely is our belief the current yield curve is confirming that we are late in the cycle.

The commonly monitored 2-year/10-year differential has yet to invert during this cycle. The chart below shows the curve measured as the rate of the 10-year Treasury yield less the 2-year Treasury yield, each time the line dips below zero (highlighted) indicates an ‘inverted’ curve.

The yield curve has inverted prior to each recession over the last 50 years. The timing of each recession following an inversion has varied (from 8 to 24 months), with an average of 17 months, with the peak in equity markets occurring on average 11 months after the inversion. From a portfolio perspective, a reduction in exposure to risk assets at the point of inversion would have been damaging to returns based on historical evidence.

At Davy we continue to closely monitor potential warning signs of the health of the global economy and position portfolios appropriately. Other indicators such as corporate bond spreads, consumer and business confidence, the level of real interest rates, and a labour market that continues to tighten point to an environment with further room to run before the end of the current cycle.

Figure 3: The US Treasury yield less the 2-year Treasury yield (%)

Source: Bloomberg

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