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Consider the shape of the curve

11 April 2019

In the last couple of months most of the headlines have focused on the shape of the US yield curve and whether it is a reliable recession indicator or not. In that context the focus has been on the difference between the 10 year US treasury yield and the 2 year US treasury yield or 3 months Libor most recently.

We would argue that by only observing the yield spread difference without a broader consideration of the economic background, investors apply a very narrow lens when trying to predict future developments. In our view various factors have to be considered.

The US economy still appears to be robust while the yield curve is partly distorted by the very depressed term premium. This premium is what investors usually demand when holding longer dated bonds in addition to any premium paid for future inflation protection. Looking at the above and the broader set of economic indicators we believe it might be premature to bet on an imminent recession.

In this article we do not intend to analyse the predictive power of the 10 – 2 year yield difference, but want to focus on the shorter end of the yield curve, mainly the one to seven year part. This allows us to provide some guidance for rate curve positioning. Interestingly enough the inversion has already taken place in the short end of the interest rate curve while yields in the long end have moved comparatively little.

Market Expectations

The graph below illustrates that change in shape of the curve compared to 12 months ago (dotted line). The reason for the change in the yield curve has been prominently discussed since the start of the year and it was induced by the re-pricing of the market expectation about the future hiking path by the Fed.

Shape of the curve chart

Previously the market was pricing in rate hikes, now it is pricing in a rate cut by roughly 25bpsover the next 24 months. Forward rates are used by professionals to visualise that market expectation. Worth noting is that many participants overestimate the predictive power of forward rates and it does not  carry any information over and above what a yield spot curve would imply already – it is simply a derivative of the spot yield curve.

The implied one month forward rate in 1 year’s time is currently 25 bp. lower (2.355) versus the current 1 month Libor rate (2.604). Even if economic data may become more volatile in a late cycle environment, it is hard to believe that the US Fed will change direction that quickly in the absence of a rapid and dramatic economic shock.

Implications for investors

The expectation of rate cut or multiple cuts seems premature and the pressure for the inverted curve in the short end to pull back to spot rates high. So what does that mean for investors?

At this moment investors do get the least value out of the three to four part of the curve and investors who share our view that the Fed is not going to cut should stay at one to two year tenors. For investors who believe the cycle is ending and that rate cuts are imminent, we would highlight the fact that the Fed has rarely left it to only one rate cut by 25 bp.

Previous easing cycles in the past have seen rate cuts by at least 75 bps, if not even by 300bps or 500 bps, as witnessed in the 90s, 2000 and 2009. In that case long dated bonds usually provide a better hedge compared to the 3 – 4 year segment. So whatever the view: consider the shape of the curve.

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