- The yield spread on 2- and 10-year US treasuries is close to inverting, which has often been a reliable indicator of recessions.
- But the fixed income chief at $US6 trillion fund manager BlackRock said investors who are too focused on the yield curve could be missing the main game.
- Jeffrey Rosenberg said instead of worrying about a recession, investors should focus on rebalancing their portfolios to maintain profits as rates begin to rise.
The yield spread on US 2-year and 10-year treasuries is getting flat. When it inverts, history says a recession usually follows.
Should we be worried about a downturn?
Well according to the chief bond strategist at $US6 trillion asset manager Blackrock, that’s not actually the right question to be asking.
Rather, Jeffrey Rosenberg warns that amid all the recent hype about the yield curve, investors could be missing the main game.
Of more importance: Competition for huge global capital flows is heating up in an environment of rising rates.
So instead of sweating on the 2-10 spread, smart investors should be considering how to position their portfolios accordingly.
“The only thing more persistent than the flattening yield curve has been market fears about the yield curve,” Rosenberg said.
“But this attention may be misdirected.”
To illustrate his point, Rosenberg compared different fixed income products using two factors — investment returns and relative volatility — for both 2012 and 2018.
In 2012, the US Fed had its foot on the quantitative-easing pedal with official cash rates anchored at zero. Fast-forward to 2018 and the “risk-free” rate has climbed to 2%.
Here’s how that change has caused a shift in returns for different fixed-income investments (warning — it’s a detailed chart but we’ll break it down):
“The other kind of flattening”
The chart shows that the composite line for different fixed income returns in 2018 is much flatter than it was in 2012.
Back then, more capital moved into high-risk debt instruments as investors went on the hunt for yield.
Riskier corporate bonds (“U.S. high yield”) gave a return of around 6% in 2012 — equal to the premium over official cash rates, which were anchored at 0%.
Fast forward to this year, and US high yield debt is still returning around 6%, but benchmark interest rates have risen to around 2%. That’s why the trend line for the green line is flatter.
The higher spread in 2012 was a symptom of the Fed’s policy stance, as it boosted the economy with unprecedented levels of fiscal stimulus.
But according to Rosenberg, a critical question remains unanswered: “What happens to markets as this process goes in reverse?”
The Fed is hiking rates now, and yields on shorter-term US Treasuries (including 2-year debt) have risen accordingly.
US treasuries are still seen as one of the safest places to park your money, so all of a sudden that government debt is looking more attractive.
The resulting shift has contributed to “bursts of volatility in global fixed income markets”, Rosenberg said.
“Why? Attractive yields on these assets are heating up the competition for capital.”
Rosenberg noted that the Fed is taking a gradual approach to normalisation and being clear in its policy guidance, in order to avoid market disruption.
Nevertheless, “portfolio rebalancing in reverse is a tricky process”, he said.
“The volatility we’ve seen so far this year – also a result of trade disputes and potential US economic overheating – suggests a more cautious approach to fixed income investing is warranted.”
Back to the yield curve
Rosenberg said the flat 2-10 yield curve may not be such a reliable indicator of recession this time around.
“It has inverted before every recession since WWII, yet we caution against using the flattening yield curve in isolation as a signal,” he said.
At the same time, he highlighted an interesting relationship between the yield curve and the US unemployment rate:
The “unemployment gap” in the chart above is the difference between the unemployment rate and the “natural” rate — a hypothetical rate, at which point inflation is expected to rise.
US unemployment just fell to an 18-year low, so the gap is narrow. And since the 1950’s, a lower unemployment gap has almost always been accompanied by a flatter yield curve.
But according to Rosenberg, that doesn’t mean a recession is imminent. BlackRock’s economic indicators still point to steady global growth ahead.
However, it does suggest we’re getting late in the investment cycle — so be cautious.
“History suggests the yield curve can stay flat for years before eventually inverting, as it did in the late 1990s,” Rosenberg said.
“The key message: We see reasons to believe the yield curve may be a less useful economic signal than in the past, but with the unemployment gap telling a similar late-cycle story, it makes sense to fortify portfolios.”
“We prefer short-duration debt and floating-rate exposures in this rising interest rate environment.”
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