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Date: May 21, 2018
Category: Alternative Investments

Don’t Press the Panic Button Over the Current Flattening Yield Curve

News outlets have been monitoring the flattening yield curve almost daily, devoting newspaper spreads and push notifications to the message: warning, danger (possibly) ahead. The headlines have forced investors to make sense of the most basic question, “what is the yield curve?” before even beginning to divert possible trouble.

The qualifier possibly should have investors searching for important context. First, understand that a yield curve is a graphical look at the different interest rates paid by bonds with similar risk profiles, but different maturities. Many yield curves look at the 2- and 10-year or the 5- and 30-year Treasuries.

Adjectives used to classify the yield curve range from normal, to flat, or inverted, all depending on the difference in yields paid by short- and longer-term bonds. Under normal conditions, a longer-term bond will offer excess compensation for taking on the risks of time. However, today’s flattening yield curve means that short- and longer-term bonds are paying nearly identical yields, with fears of an inversion ahead.

What is causing this dynamic? Short-term rates tend to rise with investors’ expectations for tighter interest rate policy.1 These expectations should come as no surprise, as the Federal Reserve has raised the fed funds rate six times since 2015, and chairman Jerome Powell has signaled at least two more hikes this year.

Conversely, long-term rates are more responsive to economic attitudes and serve as a barometer of borrowing costs for everything from car loans and home mortgages to corporate debt.1 Yet, while the rise in short-term rates makes sense to most observers, the concern comes on the back end.

As the economy continues to chug along, are long-term rates just slow to catch up, or is this a warning sign of an economy losing steam?

Why investors are panicking

Investors are concerned that the Fed’s aggressive rate path may push the United States inadvertently into a recession. The spread between 2- and 10-year Treasuries sat at 130 basis points in late January 2017, only to shrink to 41 basis points in April 2018, the narrowest spread since the Great Recession. This is bad news for activity in the largest bond market, as banks pay interest on short-term rates and lend at long-term rates.2

Market volatility has also returned in 2018 on interest rate and inflation worries, but this apprehension could indicate the return to normal market movement rather than impending doom. In February, Wall Street was concerned that the rising 10-year indicated an economy moving too fast, but one month later, it was worried about the 10-year not moving fast enough. As measures of economic health, both can’t be true.

Keep calm and carry on

The economy is in a similar position today as it was back in February. There hasn’t been a quarter of negative growth since Q1 2014, and a $1.5 trillion tax cut is forecast to add another 0.5 percent to economic growth this year, although the supply-side boost has been minimal to date.1

That tax cut is also expanding government deficits, so the U.S. government may start issuing more government debt at attractive rates to help close the funding gap. This issuance comes as the Fed is winding down its Treasury holdings, another reason long-term yields may climb to attract new buyers.

The government’s preferred inflationary tracker, the core index for Personal Consumption Expenditures, is also trending higher, advancing at a 2.5 percent annualized rate in Q1 2018, a pace unseen since 2011.

And the body in charge of balancing it all, the Federal Reserve, is not panicking. The three-month average increase in nonfarm payrolls remains above the 200,000 trendline, consumer confidence recently registered a new high, and the government’s employment cost index rose 0.8 percent in Q1 2018, just another metric indicating wage pressure.4

Buoyed by those numbers, John Williams, president of the Federal Reserve Bank of San Francisco, recently said that he doesn’t anticipate an inversion. And as the Fed continues to raise rates and shed Treasuries from its balance sheet, the belief is longer-term yields should rise as well. As Powell added succinctly about the comparisons to 2008, “that’s not really the situation we’re in now.”2

Now, commodity prices are climbing in a tight labor market, signs that point to rising inflation. And the Fed combats inflation by aggressively raising rates – basically the course it’s on now.

What’s this mean for investors?

A flattening yield curve can have a noted impact on traditional asset classes. Historically, corporate bond investors generally become more risk adverse following a flattening yield curve, perhaps because of the pressure rising short-term rates put on corporate balance sheets or because risk-free assets become more attractive for income investors.5 Also, rapidly rising short-term rates can put a dent in equities, as companies adjust to a higher cost of debt.

On the fixed-income front, the opportunity cost of rising rates presents a dilemma. If the flattening yield curve is a sign of economic trouble ahead, investors will generally look at fixed income for safety. However, if rates keep moving higher across the board, a bond bear market isn’t out of the question, especially for longer-duration corporate bonds. To minimize that risk and diversify against rising rates, duration management may be critical.

Public real estate also took short-term body blows as rates increased, but it has started to trade higher on positive fundamentals. Rates are climbing from historic lows to a range more consistent with economic expansion, and higher rates due to strong growth are generally positive for real estate and real estate investment trusts (REITs).6

At the end of the day, instead of tracking the daily yield curve, focus on economic fundamentals to calm those nerves. If the economy continues to grow and inflationary pressures take hold, the back-end of the curve may re-price, removing flattening fears from the discussion.

1 The Wall Street Journal. Flattening Yield Curve Raises Warning Flag. 4/18/18.
2 CNN. What’s a flattening yield curve and why it may be scary. 3/28/18.
3 Bloomberg. The Yield Curve is Flattening Again After Strong Eco Data. 4/27/18.
4 Reuters. Treasuries-U.S. yield curve flattened by global growth doubts. 4/27/18.
5 Seeking Alpha. How The Flattening Yield Curve Could Lead to a Bear Market for Stocks. 4/27/18.
6 NAREIT. What’s the Yield Curve Telling Us About the Outlook for the Economy and REITs? 4/25/18.

This information is educational in nature and does not constitute a financial promotion, investment advice, or an inducement or incitement to participate in any product, offering or investment. It is not intended to be used as a tool to determine your specific financial situation, tax status, investment objectives, investment experience, suitability for any specific investment, risk tolerance or investment profile. Resource is not adopting, making a recommendation for or endorsing any investment strategy or particular security.

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