What does the Treasury yield curve indicate
Yield curve reversals suggest caution rather than recession. The analysis by Marc Seidner, CIO of PIMCO's Non-Traditional Strategies
At the end of each business cycle, investors turn their attention to the Treasury yield curve, a bond market indicator seen as an anticipation of the economic outlook. The curve itself is a graph of the relationship between Treasury yields and time to maturity. It usually tilts up, left to right, to indicate that investors are demanding higher remuneration for holding long-term bonds, to offset the risk that economic growth or inflation may accelerate over time.
The inversion of the curve has been a harbinger of recession on several past occasions, when shorter-dated yields outperform longer-dated ones. Lately, reversals have appeared between several points along the curve, prompting investors to wonder if these are harbingers of a recession. This is a tricky question in the current business cycle, which has seen a sudden drop in 2020 and a rapid rebound fueled by unprecedented stimulus from central banks. The Federal Reserve began reducing this stimulus in March with the first of a series of interest rate hikes expected to tame inflation. The withdrawal of the Fed 's bond purchase program is also expected this year.
A reversal of the yield curve should never be ignored just because the context has changed. That said, the curve signal may be less clear than in the past. The flattening of the curve often occurs later in a cycle when central banks raise short-term policy rates to contain growth and inflation. Short-term yields may rise to reflect these rises, while long-term rates may fall as expectations for inflation and growth moderate. This time, the flattening happened quickly and well before the Fed's first hike. Inflation may continue to exceed expectations, which could push the Fed to further accelerate its hikes.
In our view, longer-term indicators such as the 2/10 year and 5/30 year Treasury curves may be more valuable than the much followed three month / 10 year curve. The reason is that the Fed has already exposed the rate hike projections in the dot plot, and looking at market rates over a short-term horizon may be less helpful than focusing on what the Fed claims it wants to do next. future.
The most important curve to follow is probably the forward curve, a market-based indicator that incorporates existing – or spot – rates as well as implied rates later on. For example, to compare a bond that matures in one year with one that matures in two years, the forward curve takes into account the expected interest rate one year from now. By including the compound rate of return needed to differentiate any point on the yield curve, the forward curve uses all known information and can be more relevant than a spot curve, which does not incorporate expected changes in short-term rates. The forward curve is now strongly reversed.
Does this mean that a recession is imminent? No, but it is a risk to be monitored. The global economy and policymakers are facing a supply shock that is negative for growth and will tend to push inflation further up. Most central banks seem determined to choose to fight inflation rather than support growth. This increases the risk of a hard landing in the future.
We expect higher-than-expected growth and a gradual easing of inflationary pressures from the highest peaks in developed market economies. However, the risks of higher inflation and lower growth have increased, along with the risk of a recession in 2023.
The current shape of the yield curve underlines why investors need to be flexible. The simple bond math – which takes into account the price, the yield and the reinvestment rate – suggests that investors are not reaping enough extra yield from buying long-dated Treasuries. At current levels, not only does a two-year Treasury offer a yield similar to that of a 30-year bond, but it provides the opportunity to make a two-year reinvestment decision instead of waiting for another 28 years.
With this in mind, we are slightly underweight duration, or interest rate risk, with most of that underweight at the long end of the curve. If inflation persists, it could hurt 30-year bonds more. Also, as the Fed moves from buying bonds (quantitative easing) to selling them (quantitative tightening), this could nullify some factors that stifled the term premium, or the difference between long and short term yields. We see a possible opportunity in the shorter maturities of 2-5 years. We are convinced that we are now well advanced in the economic cycle, with underlying growth momentum still strong but increasingly vulnerable to downside risk. We tend to emphasize the need to maintain liquidity to be used in order to benefit from the dislocations that will arise on the markets.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/che-cosa-indica-la-curva-dei-rendimenti-dei-treasury/ on Mon, 18 Apr 2022 05:40:54 +0000.