Voices

All eyes on the yield curve

As bond investors, we are entering the most challenging phase of the economic cycle.

Credit spreads are still near cycle lows, and virtually every fixed-income sector around the globe is posting negative returns for the year to date. The Fed has just raised rates by a quarter-point to 2. An uptick in inflation reignited some speculation there could be two more Fed hikes for a total of four in 2018.

Holman-Mark.jpg

Rates investors have suffered significant pain already this year, as the U.S. yield curve has moved sharply higher, with 10-year yields jumping from 2.40% to more than 3%. Those who had owned that risk for the full distance, mark-to-market, would have lost 5%.

Advisory clients must be on their toes to see when the end is imminent and consider their positioning if they want to avoid the downside of the cycle’s end and enjoy the upside of what follows.

The shape of the U.S. yield curve is absolutely critical to that judgment. The two-year/10-year U.S. Treasury yield curve is just over 50 basis points, and based on the Fed’s current path, our base case is a flat curve at about 3.25% within 12 to 18 months.

That is a concern, because history suggests that with a flat yield curve, investors start anticipating recession, chief executives ease back on investing, commercial banks tighten their lending standards and recession predictions can become self-fulfilling. Of all the end-of-cycle risks, this is the one that concerns us most.

The Fed's latest rhetoric has been aimed to address the flattening bias. If the curve flattens below 40 basis points, then more assertive action could follow and the Treasury could shift its borrowing further along the curve, removing some of the anchor on longer-term rates. It will be very interesting to watch Fed member comments over the next few months, as any change to the tone of forward guidance will add uncertainty to market rate expectations and put upward pressure on long-end yields.

This is why we remain extremely cautious on rates in general. Long-end rates in Europe, the United Kingdom and the United States all look vulnerable. The Fed is one decision away from steepening the yield curve and heaping serious pain on those holding long-end rates risk.

For reprint and licensing requests for this article, click here.
Fixed income Bonds Investment strategies Interest rates Interest rate risk Yield curve Treasurys Federal Reserve 30 Days 30 Ways
MORE FROM FINANCIAL PLANNING