They say a year is a long time in politics. And it sometimes seems a day is a long time in financial markets. That being so, the last time the US yield curve inverted — over 2,770 trading days ago according to one estimate — represents a relative eternity.

The last time we saw an inversion of the yield curve was before the financial crisis in 2007. Indeed, an inverted curve is regarded as a reliable recession predictor — the last seven US recessions were preceded by an inversion of the curve. Given the predictive powers of the curve, the possibility of an inversion in 2018 is understandably triggering concerns about a potential economic slowdown.

Yield curve inversion occurs when short-dated yields exceed long-term yields. And with the yield curve currently flattening due to the narrowing spread between short and long-term US Treasury yields, the prospect of an inversion looms large.

A key driver of this flattening trend has been the US Federal Reserve’s ongoing interest rate hiking cycle, with short-term yields climbing dramatically since the end of 2015 when the Fed began to raise rates. The latest action saw the Fed increase rates on March 21, 2018, by a quarter percentage point to a range of 1.5% to 1.75%, marking the sixth rate increase since 2015.

Meanwhile, the long end of the yield curve — seen as a reflection of the market’s global growth outlook — has remained in a tight range and ultimately underperformed short-term yields. Investor expectations of an economic slowdown as we move toward the later stage of the cycle point to lower long-term rates. In addition, the highly accommodative monetary policies pursued by central banks around the world have led to stronger demand for Treasuries, serving to further depress yields on longer-term US bonds.

These conditions are causing what is known as a “bearish flattening”, with short-term yields rising at a faster pace than long-term yields and, in the process, paving the way for an inversion. With the Fed’s 2018 hiking plan still on track, the possibility of a negative yield spread later in the year cannot be ruled out.

The year 2017 marked a consolidation of this flattening yield curve trend. And the twin forces that have caused the long and short end of the yield curve to converge are expected to gather further momentum. The Invesco Global Fixed Income Study 2018 shows a consensus among fixed income specialists about short-term yield increases due to central bank action over the next three years. The study suggests specialists are planning to increase allocations to core fixed income as well as adopt ladder portfolios and Barbell strategies — multi-maturity and long-short duration investment strategies respectively — that aim to mitigate interest rate risk.

Meanwhile, Bank of America Merrill Lynch’s February 2018 fund manager survey shows the largest proportion of fund managers since 2008 (70%) believe the global economy is “late cycle”, with  global growth expectations down 10% to 37%.

But while these long and short-end dynamics point toward a further flattening and possible inversion of the curve, such a scenario may not necessarily play out. The flattening trend in the US could be stabilised, for instance, if other central banks begin to tighten monetary policy this year.  In theory this would facilitate a slowdown of capital flows from other nations into the US, thereby dampening demand for long-term bonds. But in practice, any expected benefit would likely materialise over a medium-to-long-term timeframe because US longer-term real interest rates tend to follow the downward global trend. Long-term rates would need to rise in tandem with Fed rate hikes to avoid an inversion scenario and such synchronicity is highly improbable.

The long and short of it all is that the Fed’s current path of rate increases point toward a further flattening and possible inversion of the yield curve in 2018.

Given the predictive power of the yield curve, investors therefore need to ready themselves for slower economic growth and higher volatility. However, an imminent recession is not inevitable and the Fed may decide to call an end to its rate-hiking cycle or pause for thought before implementing future increases. But if the Fed continues pitching for rate hikes, investors should swing into response and be on the lookout for a possible curveball.



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