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AAM Viewpoints – Will the Municipal Yield Curve Invert?


In late August, the U.S. Treasury 2-10-year curve briefly inverted for the first time since 2006-2007 (see chart below). Though it has since steepened, many headlines were printed discussing the relevance of this event. In short, each recession over the past 50 years has been preceded by an inversion of the 2-10-year Treasury curve within an approximately 18-month timeframe. It is noteworthy, however, that not every inverted yield curve has been followed by a recession. In this week’s Viewpoint, we are going to discuss the potential for an inversion in the municipal yield curve should Treasuries invert again.

brigati1_102819

Source: Bloomberg

Aside from discussion and speculation as to the possibility that this most recent inversion may be followed by a recession, investors began to question the possibility of an inversion to the municipal curve. The below chart illustrates the U.S. Treasury 2-10-year spread and the BVAL AAA Municipal 2’s-10’s Spread (BVAL - Bloomberg Valuation Service is an evaluated pricing service offered by Bloomberg).

Here are some relevant data points that help answer the question:

brigati2_102819

Source: Bloomberg

  1. One can observe that – in general – the municipal data points are above the Treasury data points. This indicates that the spread between the 2-year and 10-year portion of the municipal curve is wider than the U.S. Treasury curve. Furthermore, it provides evidence that the municipal market includes a credit component that is absent in the Treasury market. In short, longer-dated maturities generally command a wider spread than shorter-dated maturities to account for both the inherent interest rate risk along with credit risk (albeit very small) embedded within the municipal market as maturities extend. This is not to suggest that credit risk alone would preclude the possibility of an inversion, but it is simply a dynamic within the municipal market that creates an additional hurdle to overcome for an inversion to occur.
  2. There is some precedence established during the 2006-2007 period in which the U.S. Treasury curve inverted, but the municipal curve remained positively sloped (pink oval in the chart above). As the Treasury curve inverted, the municipal curve maintained a positive slope between 24 and 93 basis points. Acknowledging that every period in time is different, this alone does not suggest that the municipal curve could NOT invert at some point in the future. However, it’s important to notice that during an extended period of Treasury curve inversion, the municipal curve did not become inverted. Additionally, during the most recent inversion at the end of the summer, the municipal curve maintained a positive slope of approximately 35 basis points.

Accounting for the aforementioned inherent credit component of the municipal market, along with the historical precedence of recent inversions, it is our opinion that investors should not be as concerned about future inversion of the municipal curve should the Treasury curve invert again. Perhaps a more pronounced inversion of the Treasury curve than we have observed in the past could help pull the municipal market into an inverted state. As it stands now, however, we believe the municipal curve should maintain its upward-sloping bias.

 

CRN: 2019-1004-7727R


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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