Should Investors Fear a Flatter or Inverted Yield Curve?

Should Investors Fear a Flatter or Inverted Yield Curve?

The shape of the yield curve—a graphical plot of the interest rate offered by U.S. Treasury bonds of various maturities—has been getting a lot of attention in recent months. Specifically, many commentators have been discussing “flattening” of the yield curve that’s occurred over the last year. Saying that the yield curve has flattened is just another way of stating that the difference between short-term interest rates (e.g., 2-year rates) and longer-term interest rates (e.g., 10-year rates) has narrowed.[1] Exhibit 1 presented below clearly displays the flattening of the yield curve as well as the general rising in interest rates that’s taken place as the Fed has worked to normalize monetary policy. Note how the slope of the curve has flattened as short-term rates—displayed on the left side of the chart—have risen more substantially than have longer-term rates.

 

 

When gauging the shape (i.e., the steepness or flatness) of the yield curve, analysts typically evaluate the spread between the 10-year U.S. Treasury rate and the 2-year rate—what’s known as the “10-2 spread.” As of August 28, 2018, this spread stood at 0.21%. At the end of September 2017, the spread was 0.86%. Many market watchers have extrapolated this flattening into the future and used it as the basis for their prediction that the 10-2 spread will turn negative in the near future. If this were to happed (i.e., if short-term rates were higher than long-term rates), the yield curve would be said to be “inverted.”

 

The potential for an inverted yield curve has caused alarm bells to go off in some corners of the investing community as the shape of the yield curve has become a trusted signal of economic health due to the close historical relationship between yield curve inversions and subsequent recessions. More precisely, the yield curve has inverted prior to each of the last five recessions. This relationship is presented in Exhibit 2 which plots the 10-2 spread (green line) and U.S. economic recessions (grey shading). Yield curve (when the 10-2 spread has turned negative) inversions are highlighted in the chart with red circles. A cursory review of the chart reveals that the the curve has inverted prior to each recession.

 

Given this empirical relationship, it’s understandable that many investors have become nervous about the prospect of an inverted yield curve and have consequently questioned whether it makes sense to de-risk their portfolio. To this, we’d like to offer a few empirical observations that call into question the merits of using the shape of the yield curve as a bearish market timing tool.

 

First, it’s important to recognize that yield curve flattening is quite common during periods of Fed monetary policy tightening. This is due to the differing degrees of influence Fed monetary policy exerts on short- and longer-term rates. Fed monetary policy directly influences short-term interest rates such that when the Fed tightens monetary policy it’s common—and expected—to see short-term rates rise. Longer-term interest rates, on the other hand, are influenced by a variety of different forces but are generally thought to be most heavily influenced by inflation and growth expectations. During periods of monetary policy tightening, to the extent that market participants expect that the Fed’s policy tightening will be effective at containing inflation (i.e., not letting it accelerate significantly or uncontrollably), it’s natural to see longer-term rates remain well anchored. Such a combination of rising short-term rates and steady or only modestly rising longer-term rates results in a flattened yield curve which is precisely what we’re seeing today and is what we’ve witnessed during past tightening cycles.

 

Second, past experience has demonstrated that just because an inversion occurs, it doesn’t signal that a recession is imminent. In fact, on average, it has historically taken 645 days from the day the yield curve first inverted (following an earlier recession) to the official beginning of the subsequent recession (see Exhibit 3). What’s more is that there has been a considerable amount of variability around this average figure. Recessions have following yield curve inversions by as little as 323 days or by as many as 1,041 days.

 

Third, a yield curve inversion has not historically heralded poor near-term stock market performance. Looking back again at the last five recessions, we can observe that, on average, the S&P 500 Index gained 13% from the time the yield curve first inverted to when the subsequent recession ultimately began. Once again, there was considerable variability around this average. It’s interesting to note that despite this variability, in each episode, the stock market was actually up during the period between inversion and recession beginning.

 

 

 

Please reach out to us with any questions you have or if you’d like to talk about your personal situation and investments,

Kathmere Capital

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

All performance referenced is historical and is no guarantee of future results.

No strategy assures success or protects against loss.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond and bond mutual fund values and yields will decline as interest rates rise and

bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Stock investing involves risk including loss of principal.

S&P 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

 

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Private Advisor Group, a Registered Investment Advisor. Private Advisor Group and Kathmere Capital Management are separate entities from LPL Financial.

 

[1] Generally, longer-term interest rates are greater than shorter-term interest rates which when plotted on a standard graph (with maturities increasing from left to right on the horizontal axis and interest rates increasing from bottom to top along the vertical axis) appears gently upward sloping from bottom left to upper right.

 

 



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