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Abrupt Change In The Yield Curve – Supports Growth Outlook

For the last year or so there has been extensive conversation surrounding the flattening of the U.S. Treasury yield curve. (The yield curve is formed by plotting points on a graph representing the yields of U.S. Treasury obligations from short maturities to long maturities; connection of those points on the chart form the yield curve.) The shape of the yield curve is often times a reliable predictor of upcoming economic expansion or contraction and changes in the yield curve tend to happen well in advance of the changes showing up in the economy. For both of these reasons, it is considered to be a valuable tool.

Most people would agree that the longer you tie up your money in a note or bond, the higher the rate of interest you should receive. That logic is very sound and is the way a normal yield curve is drawn with lower rates for a shorter note and higher rates as the maturity extends. This forms a positive yield curve, which tends to be coincident with healthy, expanding economies. However, when financial conditions begin to slow and eventually contract, the yield curve generally flattens and can eventually invert where short-term interest rates are higher than longer-term rates. Thus, yield curve watchers are very concerned when short-term rates begin to rise while long-term rates stay static or even decrease. That is precisely the concern we have had over the past year watching the curve flatten.

The first few weeks of the year have been difficult for the bond markets as yields have drifted higher than we have seen in a while. The Federal Reserve continues to put upward pressure on the short-end of the yield curve by raising short-term interest rates. This action, in and of itself, tends to flatten the curve unless long-term rates rise as well. The conjecture in the media has been that we should expect a slowing of economic growth and a possible recession since the curve is flattening. Normally we might agree with that thesis except for the huge tax cut legislation that was passed into law last December. We believe the bill likely extends the expansion by a year or two, since tax cuts for corporations and individuals puts immediate cash in pockets and provides a reason to spend. In our Best Ideas for 2018 we surmised that the fiscal stimulus would push the U.S. economy into overdrive and we should expect a steepening of the curve rather than a flattening. We believe that is exactly what we are seeing transpire.

Source Bloomberg

As you can see from the chart of 30-year Treasury yields minus 5-year Treasury yields the curve began to flatten in 2017. That has changed. We now see the curve beginning to steepen. What should we expect from here? Well, normally when we see a curve steepen, we expect GDP to accelerate. We expect earnings to continue to expand and we expect unemployment to continue to decline as the demand for jobs stays high. In short, any hint of economic slowing or recession has been pushed into the future.

What about higher interest rates? Well, if they are rising for the right reasons higher rates are a healthy thing. Normally, as GDP ratchets up, so do interest rates because the demand for credit grows and begins to exceed the amount of credit available. Inflation tends to perk up as well. Longer-term rates are set based on the supply and demand of credit as well as inflation expectations. Both are growing, so logically rates should move up.

Generally, in this environment, the equity markets can do well. Bond markets tend to struggle as higher yields push bond prices down. The brutal equity market correction that we find ourselves in currently will likely dissipate over the coming days and weeks. We believe that rising earnings expectations will translate into rising share prices. We reiterate our call for cyclicals, commodities, materials, energy, financials and consumer discretionary to outperform. We like buying where the up cycle just started such as in Europe, Asia and the emerging markets. We would use this dip to add to equity exposure. We would reduce exposure to bond duration, utilities, REITs (Real Estate Investment Trusts) and consumer durables. From our perspective, the current swoon in the equity markets gives you the chance to buy at great entry levels.

 

CRN: 2018-0202-6395 R 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.