It Is Time To Move Up The Yield Curve – ValueWalk Premium
Yield Curve

It Is Time To Move Up The Yield Curve

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Q4 hedge fund letters, conference, scoops etc

The business cycle has progressed to the point where the front end will outperform the long end of the yield curve.

In the last three recession eras (cycles 1-3 in the chart below), yields at the front end of the yield curve moved lower more than the long end of the yield curve, by a lot – an average of 1.8 times as much. This happened because as the Fed lowered rates during those recessions, the front end of the yield curve (e.g. the 2-year U.S. Treasury) followed changes in the lowered Federal Funds rate, while the long-end of the yield curve began to anticipate the stimulus of lowered rates having a positive future effect, causing them to fall less.

In bond lingo, the yield curve steepened.

Yield Curve

Because of this, holding duration-equivalent amounts of 2-year Treasuries (using leverage) will outperform the rest of the U.S. Treasury yield curve in a recession-era environment. In recent articles, I have advocated holding positions primarily at the long end of the curve. But enough evidence exists to begin moving U.S. Treasury exposure forward on the curve. Let me explain why.

A less hawkish Fed means inversion may not happen

The chart below shows the difference between the 30-year and 2-year yields over time. Quite simply, when the line rises, it is a better time to own the 2-year; when the line falls, it is better time to own the 30-year (assuming equal amounts of duration exposure). During recession eras (cycles 1-3), the line tends to go up.

Yield Curve

In the past three cycles, this line fell below zero (yield curve inversion) before it turned around and went up. The yield curve inverted because the Fed raised rates above the rate of the 30-year before everything turned around. Currently, the 30-year yield is 45 basis points above the 2-year yield (as of 1/28/2019).

It would seem logical to wait for the yield curve to invert before moving to the short-end of the yield curve, but there is a good reason why an inversion may not happen before the market begins to price in lower Fed rates. As I pointed out before, the Fed’s mandate is a coincident indicator (labor) and a lagging indicator (inflation). Because of this, the Fed has historically tightened well after when some leading indicators began to falter….waiting longer to be sure the cycle has turned.

But, as we are approaching the fourth recession in which rich data and asset prices have existed (I consider the modern era of rich data to have begun around 1990), there is a greater awareness and trust in leading indicators amongst the Fed. In the period after the last Fed rate hike on December 19 of last year, and before any economic data has blatantly suggested a recession, a whole chorus of FOMC members have laid the groundwork for not raising rates in March (including usual hawk Esther George, and past chairperson, Janet Yellen). On its face, this is just a posture of patience with a presumed bias towards raising later in the year, but, I doubt there will be enough time to raise again.

Read the full article here by Eric Hickman, Advisor Perspectives


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