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AAM Viewpoints — Recent Volatility and the Flattening Yield Curve


 

In conversations beginning as early as last June, we periodically described selected Federal Open Market Committee (FOMC) meetings as “the most important meeting in recent memory.” At the time, the meetings were important and at the time each meeting had something important to resolve or market expectations which needed to be addressed. Within a few days of the most recent FOMC meeting, a reader reminded us how we had also previously written that “when everything is breaking news, nothing is.” The irony being of course that in continuing to describe the past FOMC meetings as “the most important in recent history” or “the most watched Fed meeting since 2018,” we too have fallen into the same trap. It is perhaps best to suggest that the FOMC confab on January 26 was perhaps the most important mid-cycle meeting we have experienced this expansion. We realize this may not say much, but we suggest that this was the meeting which clearly delineated post-pandemic FOMC accommodation to a mid-cycle FOMC posture rife with talk of rate hikes and policy tightening. It is this transition, clear in both the FOMC statement and the subsequent comments from Fed Chair Powell, which one may suggest drew a line in the sand for rates and equity markets alike. The subsequent volatility following the January 26 meeting expressing how markets looked through the January meeting and began working out appropriate growth and discount rates in the post-pandemic, post-accommodative world.

Post-Federal Reserve meeting market volatility
Source: Bloomberg, ICE BAML Indices | Past performance is not indicative of future results.

AAM has always paid particular attention to the shape of the U.S. Treasury Yield Curve. While the curve has certainly been influenced by the FOMC’s explicit Quantitative Easing (QE), the curve still reflects some assessment of the outlook for the U.S. economy. As can be seen in the yield curve chart on this page, steep yield curves tend to precede and coincide with early economic expansions whereas inverted yield curves — where short-term rates are higher than long-term rates — tend to precede recessions or economic slowdowns. Between these two extremes, a flat yield curve serves as an important inflection point. Flat yield curves tend to highlight periods of transition where, in the case of mid-cycle expansions similar to what we are experiencing now, FOMC accommodation is beginning to wane and the committee shifts focus from policy accommodation to reining in an already-robust economy. Notably, the FOMC shift focuses on slowing inflation. As a result, a flat yield curve is the result of rising short-term rates in anticipation of FOMC policy changes while long-term rates tend to rise at a slower pace or tend to be be range-bound.

10-year treasury minus 2-year treasury

The tilt toward higher short-term rates by the FOMC and Powell’s resistance to being cornered on how quickly the FOMC might raise rates generated substantial price seeking in the equity and fixed income markets. Nominal Treasury yields climbed substantially in response to these events in what could be called “the great bear flattening of 2022.”

treasury yields treasury curveSources: U.S Treasury, ICE BAML Indices | Past performance is not indicative of future results.

In January , credit investors found themselves staring down the barrel of negative returns throughout all slices of the credit stack. Duration became the only factor which helped mitigate negative returns as longer-duration fixed income, regardless of rating, suffered in the recalibration of risk, growth and the economic outlook.

total and excess returns
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Source: ICE BAML Indices | Past performance is not indicative of future results.

It is important to reiterate that flat yield curves are inflection points in investing because they tend to reflect inflection points in the economy. We believe that the yield curve is best used as a forecasting tool for the next 12–18 months. January highlighted how fixed income returns over short periods can experience ample volatility. However, as the charts below illustrate, income is the predominate component of return for fixed income investors over longer periods. Again, this is consistent with our notion that investing is not timing the market but rather time in the market.

quarter-to-date returns

5-year returns
10-year returns
Source: ICE BAML Indices | Past performance is not indicative of future results. 

The FOMC’s recent tapering of asset purchases, jawboning of rate expectations, and comments made (and avoided) with regard to the speed of the tightening cycle are historic landmarks in FOMC policy. We believe these policy actions reflect how the FOMC operates when the economy is mid-cycle. History tends to rhyme and as a result, the mid-cycle fixed income investing playbook is focused on careful sector allocation and credit selection instead of wholesale changes. We continue to believe that economic growth in the U.S. will average close to 3% for 2022 and slightly lower into 2023. We also believe that FOMC actions may continue to punish longer-duration fixed income assets. At this point, and in the coming 12–24 months we continue to focus on risk-appropriate credit spread compensation in sectors that remain positioned for ongoing economic growth.

CRN: 2022-0204-9779 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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