A focus on quality as volatility persists
The risks of a prolonged U.S.-China trade standoff have increased, but we believe long-term fundamentals in emerging markets will offer opportunities.
Investors continue to closely watch the bond market yield curve’s “flat” profile that shows little difference between the yields on securities of varying maturities. Concerns over the curve escalated recently, as one section of the yield curve inverted for the first time in more than 10 years, with the yield on 5-year notes falling below 3-year notes. This has raised concerns over what it might mean for the markets and the U.S. economy. While an inverted yield curve has been a precursor to several past recessions, we do not believe a downturn in the U.S. economy is on the horizon.
The recent inversion occurred in only one part of the yield curve. Typically, the market’s focus on the yield curve generally refers to the difference in yields between the 2-year and 10-year U.S. Treasury notes. A “normal” yield curve has an upward slope, indicating higher yields for longer maturities. That higher yield compensates investors for the longer time commitment and associated risk.
The spread in yields has tightened in the past year based on several factors, including the expectation that the U.S. Federal Reserve (Fed) will steadily increase interest rates. For example, the spread on June 30, 2017, was 92 basis points (bps) as the 2-year note yielded 1.38% and the 10- year note yielded 2.30%. By the end of 2017, the spread had tightened — meaning a flatter yield curve — to 52 bps, with the 2-year at 1.89% and the 10-year at 2.41%. Fast forward to Dec. 4, 2018, when one part of the yield curve briefly inverted, the 2- and 10-year spread was only 11 bps, with the 2-year note at 2.80% and the 10-year at 2.91%.
The Fed has increased short-term rates nine times since 2015 as part of its current tightening cycle, bringing the fed funds rate to a target range of 2.25–2.50% at its December 2018 meeting. Markets generally expect the Fed will increase rates at least once in 2019, although recent volatility makes that less than a certainty. The yield on the 10-year note is much less affected by the actions of the Fed when compared with the 2-year, and tends to be more sensitive to investor concerns about gross domestic product growth, inflation, trade, regulations and taxes, to name a few key factors.
Past performance is not a guarantee of future results. Source: U.S. Treasury; yield curve chart on 12/31/2008 versus 12/31/2018; for illustrative purposes only.
The short end of the curve primarily is being affected by the Fed’s decision to bring the key fed funds rate to what it considers neutral, meaning it neither stimulates nor restrains economic growth. The long end of the curve is being affected by the “push” of increased Treasury supply from budget deficits, the Fed’s balance sheet normalization and an increased term premium versus the “pull” forces of global trade/growth concerns, a strong U.S. dollar, a global search for yield, political concerns and emerging market volatility. The pull factors currently outweigh the push factors, although we think that reflects a consequence of investors’ concerns about potential economic troubles ahead. Ideas of an inverted yield curve have added to those concerns because of the potential it would predict recession and the psychological affect that could lead to a market sell-off and hurt consumer confidence.
We believe the yield curve will stay flat for the foreseeable future, but we also must balance this with recent market volatility and the statement from Fed Chairman Jay Powell that current interest rates are “just below” neutral.
Since 1981, there have been four U.S. recessions. An inversion of the yield curve has preceded them all. The past recessions began from six to 24 months after the inversion in the yield curve and averaged 17 months in duration.
Source: Federal Reserve Bank of St. Louis; interest rate spread of two-year versus 10-year U.S. Treasury notes, shown in percent.
The yield curve did invert briefly during June-July 1998 before steepening again without a recession following closely. But another inversion in February 2000 preceded the 2001 recession.
An inversion in the 2-year/10-year Treasury spread thus appears to have been an effective predictor of recession. A flat yield curve, on the other hand, does not seem to have much predictive power. As an example, during the period Dec. 1, 1994, to Jan. 31, 2000, the average 2-year/10-year spread was 34 basis points and market returns remained healthy. Additionally, the inversion of the 3-year/5-year Treasury spread, similar to what we saw recently, has historically been poor at predicting recessions. According to Fundstrat, that portion of the yield curve has inverted 73 times since 1954, but only predicted a recession nine times.
While an inverted yield curve indicated future economic weakness, it has not called a top in equities. On average, equity markets peaked about seven months before the start of each recession and 10 months after the yield curve has inverted.
Past performance is not a guarantee of future results. Source: Federal Reserve Bank of St. Louis and Morningstar Inc. Period return refers to the time from the month of inversion to the month of equity cycle peak. All returns stated are as of the last day of the month noted.
The yield curve is flat and has been for some time. The U.S. economy has been in economic expansion mode for nearly 10 years, the second-longest expansion on record. Many feel we are in the later innings of this expansion, but corporate profits are not showing signs of weakening. While volatility has increased, we do not believe a downturn in the U.S. economy is on the horizon. The historic delay between an inversion and the start of a recession means there typically has been ample time to make portfolio adjustments if desired.
Past performance is not a guarantee of future results. The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through December 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. Fixed-income securities are subject to interest rate risk and, as such, the value of fixed-income securities may fall as interest rates rise.
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. The Russell 2000 Index measures the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. It is not possible to invest directly in an index.