What’s in a Yield Curve?
As of late there has been much press with regard to rising yields of sovereign debt (principally US Treasuries): especially the perceived movement of this curve and import of such changes. It is not a new dynamic (as this ‘Visual Capitalist’ article reveals from 2018) but a force that continually affects an Investor’s perspective at any given moment in time. As the saying goes: ‘same same, but different’.
Traditionally, the yield curve has a profound impact on investor’s sentiments as it reflects the state of the economy as well as possible future developments. For example, “inverted yield curves” have historically been harbingers of recessions. Bond yield curve assessments can (and do) influence actual Equity investments.
Bonds and Smart money and co?
The investment adage is that the ‘smart money’ is in Bonds; versus the more short-term, sentiment-driven, Equity markets. The Bond market is the realm of hard-nosed number crunchers and astute value investors. The safe haven. These Bond investors are serious people and generally rational given the importance of Bonds to: pension funds the world over; American 401K pension investors and basis of capital investments.
The Bond market is the basis of everything. Treasuries supposedly provide the ultimate financial benchmark: the “risk-free rate”, the measure against which the “risk premium” for all other investments are measured. Also, Treasuries provide a basis for “hurdle rates”, the discounting factor for everything from stock returns to real-world decisions on capital expenditures. In addition, a comparison of Treasuries versus Treasury TIPS provides a guideline for expectations with regard to inflation/deflation.
Faith in the Fed’s hand on the wheel?
The setting of interest rates is the preserve of central banks and the main monetary tool. Yet, for the last decade they have relied on “forward guidance” and “quantitative easing”.
In an environment of negative interest rates, combined with gargantuan levels of liquidity as well as levels of debt (sovereign, corporate and personal) that further tools are required to stimulate the economy. It may well be that the Fed indulges in Yield Curve Control to try and keep the rate of Inflation below 2%. This mechanism means holding short-term rates low and managing longer-term rates. Growth and Employment remain the central bankers’ overall goals: beyond bailing of an already swamped boat, buffeted by Hurricane Covid. An additional layer to YCC is that the ECB and BOJ have both pursued YCC for many years. With the Fed potentially employing the same practice, price discovery evaporates and with it the opportunity for the Bond investors to maintain their “smarts”! Pension funds and Insurance companies are forced to hold a certain percentage of their assets in Bonds, which co-opts them to be (unwilling) stooges to the Government’s programme of control.
What shape?
The entire yield curve encompasses the major cross currents of individual and institutional needs as well as preferences, inflationary (and occasionally deflationary) expectations, and the length of time over which unexpected events may occur. Two yield curve metrics that are most closely followed are: the “10 year-3 month”; as well as the “2-10 year” (favoured by Equity investors).
Yield curves vary along a continuum. The shape of the yield curve provides a base-case for a of- the-now perspective with regard to the economic future. One of four broad shapes can be discerned at any point in time.
Normal: starts with low yields for lower maturity bonds, increasing with higher maturity, and thus slopes upwards until flattening and remaining consistent over the longest term
Steepening: the rate of increase is greater, usually a higher rate than Normal curves across all maturities, and higher maturity yields don’t flatten but continue to rise. Such a curve implies a growing economy moving towards a positive upturn. It is accompanied by higher anticipated inflation, which often results in higher interest rates.
Flat: shows similar yields across all maturities, with little difference in yield to maturity among shorter and longer-term bonds. It implies an uncertain economic situation, be it: the end of a high economic growth period that is leading to inflation and fears of a slowdown as well as interest rates may be increased.
Inverted: means that short-term interest rates exceed long-term rates. Such curves are rare, but has been the situation for the last 24 months. It strongly suggestive of a severe economic slowdown and warning of a recession.
Do these curves predict or reflect?
According to recent data from the NY’s Federal Reserve the probability of a recession is low (chart 1).
But academic analysis and forensic studies suggest that the Fed’s prediction accuracy is less than 1 in 5. It is worth remembering that since 1953 the US economy was in a recession only about 14% (111 months out of 792) – a light grey swan!
The Equity boom since March 2020 has been based on a belief in the intrinsic value Technology stocks. To many observers driving an asset bubble. Since December 2020 the yield curve began to steepen; and this development has been a cause of investor concern (chart 2). The steepening development of the yield curve development signals changing perspectives and sentiments; and has led to a period of reflection.
As of late a fear of Inflation has been encouraging investors into a traditional flight-to-safety reaction: with a classic rotation of their investments into precious metals, commodities, real estate assets (writ large) and value stocks. Currently the major Equity markets are all off their recent highs.
Whither the economy and markets?
Most Equity investors examine the relation of the 20-2year Treasury bonds.
Yet there are other relationships to consider in the context of tattered central banker credibility as well as: the effects of: prolonged QE; negative interest rates; the monstrous debt obligations (public-corporate-private) that have been amassed as well as; the gargantuan Biden stimulus programme for Covid relief (to be followed by an Infrastructure package twice as big) filtering into the World’s economy.
What is uncertain is the investment behaviour of the growing body of Generation Y, X, Z investors. They may place more faith in the viability and reliability of the titan FAANG corporates, rather than government institutions. The rise in Retail investor activity may cause an upset to traditional assumptions: Tech vs Treasuries; Crypto vs Dollar; resilience of traditional short-sellers, etc.
It could be that the current shape of the yield curve is flattening; a slight pause before accelerating rapidly through to the summer. Such a development would signal a rally in Equities from Easter towards the summer months of 2021. The interplay of: equity markets low/high oscillations; debt levels (especially Junk bonds); currencies, especially the relative strength of the US Dollar; the management of the Chinese domestic economy; crude oil prices; commodities and precious metals (Gold-Silver-Copper) will have a bearing. All the usual set of suspects but aligned differently.
Take-aways: possible opportunities for the prepared.
If one interprets the yield curve et all in this manner then there may well be a mini-boom in Equities: a combination of renewed confidence in Tech stocks as well as classical defensive Value stocks. A covered call approach, such as The Written Fund, may also be worth considering.
The real point of reflection may well be in August and the Fall months; as the Fed’s manipulations play out and central bankers’ collective credibility is tested. Then ‘quality’ Equity investments are likely to come into their own.
Reset the rigging; the winds are shifting.
For further information contact us at info@gatecapitalgroup.com.
RISK WARNING
The views expressed are those of the author alone. Investing in any financial instrument carries risks. Your capital may be at risk. Certain investments maybe long term and may not be readily realisable. Please consider all risks before investing. Gate Capital Group Ltd is authorised and regulated by the Financial Conduct Authority (FCA Number 189170).