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.
Tight spreads, flat curve
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.
Yield curve much flatter than it was 10 years ago
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.
Yield curve as a predictive tool
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.
Inversion of yield curve was harbinger of past U.S. recessions
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.
Inverted yield curve has not predicted equity market moves
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.
Ivy view: Recession not on the horizon
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.
Different environment, same approach?
In this new environment, future Fed action might not look like the past. Check out this highlight from the recent Ivy Live to hear our take.
Get the full perspective
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.
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