The difference in the yields between short-term and medium-term interest rates is narrowing, and that’s unnerving some bond market watchers.
The spread between the yield on the two-year and 10-year U.S. Treasury notes is about 57 basis points, with the two-year yield at 2.08 percent and the 10-year at 2.65 percent. In normal markets, yields for longer-duration bonds are higher than shorter-duration securities to reward investors for taking on the added risk of tying up their money for a longer time. When short- and long-term yields are closer together, that’s known in bond market parlance as a flattening yield curve.
It can happen for a number of reasons, but a flattening yield curve always sparks concern. If the yields for different durations narrow to such an extent that the yield curve inverts — meaning short-term yields are greater than long-term yields — a recession is highly likely.
“Yield-curve inversions are the best signal of recession,” says Robert Doll, senior portfolio manager and chief equity strategist at Nuveen Asset Management in Chicago. In fact, an inverted yield curve preceded the last seven U.S. recessions, says Steven Wagner, chief executive officer and co-founder of Omnia Family Wealth near Miami.
[See: 7 ETFs to Buy as Interest Rates Rise.]
But narrow yields between the two-year and 10-year U.S. Treasury notes, the most commonly watched yield curve indicator, doesn’t mean the spread will invert. While it could happen, some bond market watchers say current economic and monetary conditions may prevent an inverted yield curve, at least for 2018.
A flattening yield curve is normal at this stage. Wagner says it’s not unusual for the yield curve to flatten late in an economic cycle, which is where he believes we are, especially as stock prices soar. “We haven’t had a recession since 2009, so we’re eight years into a fairly elongated cycle,” he says.
The yield curve has flattened over the past two years since the Federal Reserve ended quantitative easing, the monetary policy that kept interest rates ultra low, and began slowly raising interest rates, says Andrew Hart, president and chief advisor at Delegate Advisors in Chapel Hill, North Carolina. Because the Fed only controls short-term interest rates, its monetary policy affects the short end of the yield curve more than the long end. Although the Fed’s actions can trickle up the yield curve, other conditions can influence longer-dated maturities.
By buying longer-duration Treasurys and similar debt in November and December, pension funds triggered the recent concern about the yield curve flattening, says Charlie Ripley, senior investment strategist for Allianz Investment Management U.S. in Minneapolis. Because bond prices and yields move in opposite directions, those purchases temporarily pushed up longer-duration bond prices and lowered yields. “That could have put a little bit more pressure on the back end of the curve,” especially as the Fed plans to continue raising rates, he says. Since the end of last year, the spread between the two-year and 10-year Treasury notes rebounded somewhat from their low point, Ripley says.
[See: 9 Ways to Invest in America With Bond Funds.]
A reprieve for now, but stay alert. None of the experts we spoke with expects the yield curve to invert this year, given the economy’s strength. Hart says the CME Group’s federal funds futures contract doesn’t show short-term interest rates moving much higher in 2018, even after pricing in two interest rate hikes for the year. Those increases wouldn’t be enough for short-term rates to overtake long-term rates just yet.
Still, the Fed is not the only central bank raising rates. The European Central Bank and the Bank of Japan either are in the process of withdrawing or plan to withdraw their quantitative easing programs, Ripley and Doll say. With less buying of government debt, interest rates should rise. The Fed is already reducing its balance sheet by not replacing maturing debt with new debt. Ripley says foreign buyers are doing something similar, as China’s Treasury holdings fell to the lowest level since July and Japan’s Treasury holdings fell for the fourth straight month in a row.
Plus, Ripley says the Fed has been slow and methodical about raising rates to avoid triggering an inverted yield curve. With global monetary policy returning to normal and the world’s economy growing, deflation is less of a concern, and in the U.S., production capacity is rising, Doll says. He predicts the 10-year interest rate could rise to 3 percent in 2017, especially if rates can break through last year’s high of 2.63 percent.
Wagner says his firm is closely watching the yield curve and investors should use this time to review their asset allocations particularly in relation to risk. After the market’s record highs, asset allocations could easily be skewed too heavily toward stocks. His firm is already limiting its clients’ equity exposure. “We do want to trim back as we see the yield curve decline, and as equities go up, we will trim back more,” he says.
[See: 9 ETFs That Go Up When the Market Goes Down.]
An inverted yield curve is not a tool for trying to time market trades. “Don’t try and use this as a way to plant positions,” Wagner says. The period between when the yield curve inverts and a recession begins can be as little as nine months to as much as two years. The yield curve, he says, is really your cue to start thinking about risk and if you should dial it back.
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What Is a Flattening Yield Curve? originally appeared on usnews.com
