What to Make of the Flattening Yield Curve

The Rate Hike Cycle
The bond market has garnered a lot of attention in 2018. After a record run for the stock market, concerns about interest rates and potential inflation sent the market into correction territory in the first quarter. After finally embarking on a rate hike cycle in 2015, the Federal Reserve (Fed) is expected to ramp up the pace in 2018. We have already seen one rate increase and futures markets are now pricing in a 50% probability that we will see a total of four increases in 2018.

Effective Fed Funds Rate

Source: New York Federal Reserve

A Bear Market in Bonds?
Investors now fear a bear market in bonds due to rising interest rates. Over the past year the Bloomberg Barclays US Aggregate Bond Index is down 0.39%. But what does a bear market in bonds look like? Since 1976, there have been three negative calendar years for the index: 1994 (-2.92%), 1999 (-0.82%) and 2013 (-2.02%). It is important to understand that bond prices move inversely to interest rates, or in other words, as interest rates go up bond prices go down. Also, the longer the term of the bond, the more sensitive the price is to interest rate moves.

If we use an investment in the 10-year Treasury Bond as a proxy for longer-term bonds, we find 16 years with negative returns since 1927. The worst being 2009 when the return was -11.12%. However, in 2008 an investment in the 10-year Treasury returned 20.10% and in 2010 it returned 8.46%. Of those 16 instances, only three corresponded with negative returns for the S&P 500. In 1931 the 10-year treasury return was -2.56% while the S&P 500 declined 41.84%. In 1941 the return was -2.02% versus -12.77% for the S&P 500, and in 1969, -5.01% versus -8.24% for the S&P 500. Generally, in years where the 10-year Treasury return is negative we see very positive returns for stocks.

Below, we illustrate three periods with a cluster of negative returns or a “bear market” in bonds based on the 10-year Treasury.

Based on historic data, we find that a bear market in bonds is nothing like a bear market in stocks. Based on high quality bonds proxies such as the Bloomberg Barclays US Aggregate Bond Index and the 10-year Treasury Bond, we find that bear markets in bonds tend to be shallow and simply represent a short to intermediate period of slightly negative to below average returns. In the examples above, an investment in the 10-year Treasury Bond produced cumulative returns of -1.85% (1955-1959), -3.45% (1967-1969) and -3.10% (1977-1980). However, they were offset by positive returns in stocks, so a diversified portfolio faired alright through each of the periods. One explanation for this is that rising interest rates normally coincide with an improving economy, which over the long-term is good for stocks. Of course, at the end of the economic cycle we may see inflation and thus the Federal Reserve raising interest rates in response. This can lead to a slow down in the economy and a correction or bear market in stocks.

The Flattening Yield Curve
With the Federal Reserve fully committed to its current rate hike cycle, we have seen a significant flattening in the yield curve. In this case it is because the short-end of the yield curve is rising at a faster rate than the long-end of the curve. Over the past year, the 2-year Treasury yield has increased by 1.25% while the 10-year and 30-year have increase by 0.71% and 0.24%, respectively.

Treasury Yield Curve

Source: US Treasury

The flattening of the yield curve has some investors concerned because, at extremes, when the yield curve inverts and short-term rates are higher than long-term rates, history suggests that a recession is just around the corner. We still have some time to go but with two to three more rate hikes from the Fed this year, further flattening is likely.
With inflation in check, at or below the Fed’s target of 2%, and economic growth accelerating, we must ask why the Fed is so intent on raising rates and why long-term rates are not moving up as fast as short-term rates.

First, the Fed’s response to the Financial Crisis was the most aggressive monetary stimulus in the history of our country. With the economy on solid footing it is important for the Fed to normalize its policy. Even after six rate hikes, the monetary environment is still very accommodative and easy money has spurred on significant risk taking in markets and the economy. Too much risk-taking leads to bubbles and when bubbles pop significant damage is done to the economy. Many would say we are already in a bubble but only time will tell whether that is true. There is no doubt that stock valuations are above historic norms and certain real estate markets have become elevated. The Fed believes it is necessary to continue to increase rates to offset any inflationary pressures that may come about from the current government fiscal stimulus and to keep markets from overheating.

This explains why the short-end of the yield curve is rising but the long-end is holding relatively steady. We believe this is for two reasons. First, US government bonds yield significantly more than other government bonds. The 10-year Treasury yields approximately 2.3% more than the 10-year German government bond and 1.4% more than the UK 10-year government bond. This higher yield attracts foreign monies looking for better yields. But primarily, it reflects the market’s long-term inflation expectations. Last week, the Congressional Budget Office (CBO) lowered its non-accelerating inflation rate of unemployment (NAIRU) estimate from 4.7% to 4.6%. NAIRU represents the level of unemployment at which it does not cause inflation. When the unemployment rate gets too low, wages push higher and with more money in their pockets consumers demand more goods, thus pushing prices higher. The Fed’s NAIRU estimate is 4.5%. Research from Ned Davis Research suggests that the key unemployment level to look for is 0.8% below the Fed’s NAIRU estimate. That would be 3.7%. With the unemployment rate at 4.1% it appears we have a little further to go before inflation becomes an issue.

Conclusions
We fully expect interest rates to rise over the remainder of 2018 and for bond returns to be lower than historical averages in the coming years. It is important for investors to understand that just because the word “bear” is in a bond bear market, it does not mean that large losses are imminent. Bonds pay interest and return principal at maturity. Therefore, high quality bonds do not expose investors to the same risks as stocks and bear markets in bonds are mild compared to bear markets in stocks. We believe that reducing long and intermediate-term bond exposure and adding short-term high yield bonds is a good way to reduce interest rate exposure while maintaining yield in bond portfolios.

As always, we welcome your feedback and questions.

Jeremy Nelson

Advisory services offered through Sowell Management Services, a Registered Investment Advisor. The views expressed represent the opinion of Element Wealth. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Element Wealth’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

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