Weekly Investment Commentary: Why the yield curve is flattening: investment implications
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- Recession? No. Rate hikes? Yes. While a flat or inverted yield curve has sometimes predicted the end of a growth cycle, we believe the current U.S. expansion is alive and kicking. From this perspective, the flatter shape of the curve looks more indicative of today’s economic heat wave (and a nod to the near-certainty of associated Fed rate hikes) than of a cold snap farther down the road.
- Markets apparently agree. Shorter-term yields – which are highly sensitive to changes in Fed policy – have risen much more than longer-term yields (Figure 1). This implies aggressive tightening at first and a moderating pace later on as some heat is taken out of inflation and the economy. Such a scenario works only if Fed officials resist the urge to move too fast, too soon. The risk of their going “too far” may be remote, however, as the market has already priced in as many as seven rate hikes for 2022.
- Real interest rates (nominal rates less the rate of inflation) have climbed markedly, and the real yield curve remains steep — another indication that bond markets are not worried about a recession. Put another way, while inflation expectations are driving nominal short rates higher, investors remain confident the Fed will keep inflation contained in the long run.
- What does this mean for portfolios? Watching the curve’s shape and movement is prudent, but we wouldn’t rely on an inversion of the curve as a timing signal. Historically, even after an inversion, most asset classes have produced healthy returns in the subsequent years (Figure 3).
What does this mean for portfolios?
- To start, we don’t think now is the time to get defensive. Although bearish indicators have stolen headlines this year, the probability of recession implied by the shape of the yield curve remains low at approximately 6% today (Figure 2).
“We don’t think the flattening yield curve signals a recession. Now is not the time to get defensive.”
Positioning for a high wage-inflation environment
- Further, we don’t think investors should rely on an inversion of the curve as a timing signal. The yield curve tends to flatten during hiking cycles and typically inverts during or afterward. But historically, even after an inversion, most asset classes have produced healthy returns (Figure 3). So even if investors think curve inversion is a reliable risk-off signal (we disagree), two years is a long time to be sitting in cash and underperforming strategic benchmarks and peers.
Where does that leave investors? Two differing approaches
If, like us, you’re in the camp that a flattening or inverted curve does not signal an imminent recession, we think it makes sense to maintain risk-on positioning. We continue to favor a shorter duration posture (e.g., broadly syndicated and private loans), non-U.S. and U.S. small cap equities and select private assets (e.g., private equity and real assets) that tap into extended segments of the investable universe but have embedded volatility-mitigating qualities.
But what if we’re wrong? If you think an inverted curve turns the future upside down, consider de-risking by reducing overall equities exposure and/or favoring low-volatility, income-generating stocks, and by extending duration into core bonds.
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Endnotes
Sources
All market data from Bloomberg, Morningstar and FactSet
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