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AAM Viewpoints – Clashing Yield Curves – What's Next?











Something very rare has been occurring in the U.S. Treasury market; two different yield curves of the same asset class are headed in opposite directions. Yes, that is correct. The much talked about 10-year Treasury yield minus the 2-year Treasury yield has been flattening since its last peak at the end of 2013. The same could have been said for the 30-year Treasury yield minus the 5-year Treasury yield except for the last six months. Interestingly, the 30-5’s has been steepening while the 10-2's has been flattening. This divergence does not happen that frequently and indicates that the next move for the 10-2's will likely be to steepen, as opposed to inverting. This is not the consensus position and we believe it requires a serious look. In fact, we think those asset managers that are positioned defensively in anticipation of a recession may be premature.


Why should anyone care about the divergence of the two curves? Many market participants pay very close attention to yield curves as they tend to be an early and accurate indicator of the direction of the U.S. economy. In fact, they are likely one of the most accurate forward-looking indicators of upcoming recessions. They are not 100% accurate but, as shown in the chart below, every recession over the last 70 years was preceded by an inversion of the 10-year minus 1-year U.S. Treasury curve. When the yield curve steepens (i.e. short-dated yields are lower than longer-dated yields) that is a normal occurrence and is generally coincident with economic growth. Flattening yield curves and especially inverted curves (i.e. long-dated yields are lower than short-dated yields) generally precede economic slowdowns and – after inversion – potentially economic recession.


Yield Curve & U.S. Recessions


Not every inversion indicates a recession, but they do tend to predict economic slowing with a very high level of accuracy compared to other indicators. It is not normal for longer-dated yields to be lower than short-dated yields. Generally, investors expect to receive higher yields the longer they lend money. Inverted curves provide exactly the opposite. Investors get less yield for investing longer. Thankfully, inverted yield curves are rare, but when they come they tend to be harbingers of economic slowing and thus indicate potential changes in company earnings. The good news about inversions is that when they happen they generally give you plenty of notice to modify your risk assets prior to a recession beginning – generally 8-14 months. This means that equity markets tend to continue to rise 8-14 months after the inversion. The table below shows every recession going back to the 1950s using the same 10-year minus 1-year U.S. Treasury curve.


Inverted Curves & Recessions


What is so interesting about the divergent yield curves we outlined in the first paragraph is that two curves of the same asset class are telling us two different stories. Which one should be believed, if either? Well the likely answer might surprise you. Divergences between the 10-2’s and the 30-5’s are relatively rare but have happened in history. Our next chart shows these two yield curves overlaid dating back to 2000. During that time a divergence has occurred eight times and, in each case, the 30-5’s led the 10-2’s. Thus, if history is any guide, it is most likely that since the 30-5’s is steepening the 10-2’s will follow. That is what we believe to be the case this time as well.


scolyer3_012819

Source: Bloomberg




This is significant because the steepening of curves indicates a resurgence of U.S. economic growth. Remember, yield curves are leading indicators. If the curves stop flattening and begin to steepen in unison, then we should expect U.S. economic growth to speed up sometime in late 2019. This also means that the consensus opinion that the curves will invert, and the United States will enter recession is not correct. We believe this key difference provides an opportunity for advisors to modify their asset allocations from defense to offense.


We are not able to accurately tell if the 30-5’s has put in a longer-term bottom; our chart tends to show that we are close to the bottom of our last inversion which occurred in 2006/2007 (preceding the 2008/2009 recession). It is possible that the 10-2’s could steepen only for a few months and then return to a flattening trend. We know that the Fed is very sensitive to this and is trying to avoid inverting the yield curve while still normalizing monetary policy. We think the market is correct to expect minimal rate increases in 2019. We also believe that the potential of a rate cut is not in the cards yet for 2019 and, if it turned out to be warranted, we would have to re-think our strategy.


With the recent market volatility, we believe many investors are misallocated. Further, we believe that even if the curves converge and flatten, investors likely will still have months to experience the final push of the bull market. Generally, the last phase of a bull market – as measured from the inversion to peak – has tended to yield prolific returns. Bull markets end with euphoria. What we have is fear and loathing.


We like corporate credit. At the end of 2018 we saw corporate yield spreads to the U.S. Treasury market widen giving credit buyers more yield for the risk taken. In times of economic growth and strong corporate balance sheets we think a good place to be is in corporate credit. We also believe that municipal credit will bear fruit. Equity market valuations around the globe have become much more reasonable over the past three months. We like energy, financials, industrials, healthcare and consumer discretionary.


Finally, we think a Fed on hold is good for emerging markets and European markets where QE (quantitative easing) is still being applied in big doses. Yes, even China is exciting as we believe recent aggressive fiscal and monetary easing will payoff big with any trade resolution. Current worries are already baked into these markets.


In conclusion, we believe that a somewhat rare condition is playing out in the U.S. Treasury market. The 30-5-year curve is steepening while the 10-2-year yield curve is flattening. In similar situations in history the resolution of this divergence has been that the 10-2-year followed the 30-5-year. If that occurs this time, we feel that investors are not correctly allocated. We believe the resolution of this divergence will give investors a big opportunity as the divergence corrects itself.


 


CRN: 2019-0110-7152R

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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