February 1, 2019. By J.D. Wolfsberg:

With a volatile interest rate environment, the yield curve is often the topic of discussion in the business media. However, this topic and its implications are not always fully understood by the general public. In short, the yield curve is a chart that measures bond investors expectations of interest rate risk and if understood correctly may help gauge the direction and health of our economy.

Normal Yield Curve Image

The economic theory that drives the shape of the yield curve evaluates the relationship between yields, or interest rates, and consumer expectations regarding inflation. As inflation and expectations of future growth go hand-in hand, negative consumer sentiment may lower inflation expectations. With lower inflation, the inflation premium that is included in longer-dated bonds declines, therefore lowering the yield of longer-dated bonds. As a result the lower yields face additional downward pressure from consumers valuing future consumption more than current consumption; this means that they are willing to pay a higher price for longer-dated bond in the future. Yields move inversely to price, and as consumers have increasingly negative expectations of the future, longer-dated bond yields are driven down. In contrast, short-term rates are determined primarily by central bank policy. When central banks keep rates steady or hike rates at the front end of the curve, and consumer and inflation expectations push yields down on the long end of the curve, this causes the yield curve to flatten and potentially invert.

There has been an inversion of the yield curve (2-year interest rates exceeding 10-year interest rates) before every recession in the United States for the past 50 years, but it is important to note that there have also been inversions without a recession following. There have been numerous blogs, articles, etc. suggesting that it is different this time due to structural changes from the central bank’s bond buying program as well as demand for long-dated bonds by pension plans. However, Ben Bernanke, the former Fed Chairman, stated that the curve was being distorted by structural forces in 2006 before the Great Recession in 2008. To date, the yield curve has a more successful track record than economists when it comes to predicting recessions. It has not inverted yet during this cycle, despite the media coverage on the inversion between 2-year and 5-year yields. Again, an inversion is defined by 2-year yields surpassing 10-year yields.

Inverted Yield Curve

It also should be noted that predicting interest rates and anticipating yield curve shifts is extremely difficult to do. When considering a flattening yield curve, for most investors, the primary thing to think about is always their strategic asset allocation between the different asset classes within the portfolio. Secondly, diversification within the fixed income allocation of the portfolio should be considered. Not only between different fixed income sectors, but time diversification along the yield curve as well. The yield curve doesn’t only steepen or flatten, but it can twist (long term and short-term rates increase, while medium term rates decrease, or vice versa), increase in curvature, and decrease in curvature as well.

Diversifying along the yield curve allows for an investor to minimize the impact of unexpected rate movements along different points (key rates) in the curve. This is one of the reasons laddered bond portfolios are so popular, as they provide natural diversification along the curve. Lastly, if an investor wishes to be more tactical, the aspect of a flat yield curve they should consider is that they may be able to minimize interest rate risk without reducing return by too much by moving down the curve. For example, at the time of this writing, the 2-10-year (as of 1/28/2019) Treasury spread is approximately 15 Basis Points (2-year yield is 2.60% and 10-year yield is 2.75%). An investor could capture 95% of the 10-year yield by investing in the 2-year bond while incurring substantially less interest rate risk than an investor in the 10 Year Bond faces.

Although speculation on yield curve movements and interest rates may entice individual investors to make significant shifts in their fixed income allocation, it is important to remember the role that the asset class often plays in a portfolio. Fixed income’s role is to often act as the less volatile ballast when equity markets experience corrections and-sell offs. As recently as February 2018, investors were reminded that equity and fixed income markets are not necessarily always negatively correlated where fixed income goes up when equities go down. Instead in this scenario, the equity markets sold off due to rising yields. These rising yields affected long dated bonds the most due to their heightened sensitivity to interest rate movements. The lesson being that before shifting the fixed income portfolio’s maturity due to what media outlets are reporting regarding the yield curve and interest rates, it is important to remember what the fixed income asset class’s purpose is in the portfolio.