Inverted Yield Curve Signals Caution, Even if Recession Remains Distant
Head of U.S. Securitized Products John Kerschner and Co-Head of Global Credit Research John Lloyd discuss the inverted yield curve and its implications for bond investors.
- While recessions have historically been preceded by an inverted yield curve, the time to recession has varied widely; unprecedented central bank intervention into markets makes the timing even harder to predict this time around.
- It is worth questioning whether the curve has inverted because investors think the fed funds rate is too high for the path of future growth, or because investors are turning to U.S. Treasuries in a yield-starved global environment.
- There are still yield opportunities to be found; however, we do not believe investors are getting paid to stretch for yield in this uncertain environment.
John Kerschner: So, the yield curve is currently inverted and a lot of people have questions about what that means. The reason why you’ve read about it so much in the press or maybe people have been talking about it is really every recession going back 60, 70 years has been preceded by an inverted yield curve. And really, all that means is that investors out there in Treasury bonds are getting concerned that the fed funds rate, that the Federal Reserve sets, is too high compared to what’s going on in the economy. So short-term rates are high, that’s what the fed funds rate is, and long-term rates come down or below the short-term rates in order to compensate for the slower growth going forward.
The real conundrum here is that all it’s telling us is that a recession is eventually going to come. We know that anyway. Recessions are inevitable at some point. What it doesn’t tell you, is what the timing is. And when the yield curve inverts, recessions have come as short as six months and as long as four years. On average, it’s usually 18 to 24 months.
John Lloyd: I think what makes this time, John, even harder to predict the timing and whether inversion will lead to a recession going forward is we have in our first time in history, global central bank intervention into the markets. And on top of that, and also being caused by that is globally, yields are very, very low. So, a lot of negative yields out there. Germany just issued a 30-year bond with a negative yield on it. Another interesting stat out there is if you look at non-U.S. debt, it yields 11 basis points.
Kerschner: On average.
Lloyd: On average, yes. So, there’s really no yield outside the U.S., which is forcing a lot of foreign investors into our market, buying Treasuries, buying investment-grade credit and forcing those yields down. And they’re going out on the curve. So is it investors being cautious buying Treasuries, thinking the fed funds rate is too high, or is it investors just searching for yield in a yield-starved global environment?
Kerschner: That’s right and a lot of investors are coming to us looking for answers because we are bond managers and the nice thing is, even though you read these headlines about the German Bund, 30-year negative rates and there are a lot of negative-yielding investments out there in bonds, there are still areas where you can find decent yields. I know I see some of those in securitized where you can still get 3%, 4%, 5% yield, sometimes even higher. And I’m sure in your world in corporate bonds, you’re seeing that as well.
Lloyd: Yes, and I think the message to investors now is, we don’t know if this time is going to be different so it probably pays to be more conservative in your portfolios. You’re not getting paid really to own cyclical or stretch for yield in this type of environment. And you’ve even seen that in the market where the lower-quality of high yield has actually already started to underperform the higher-quality high-yield bonds. And it’s just a sign out there that you want to be conservative, you want your bond portfolio focused on risk-adjusted returns.
Kerschner: Yeah, we’re seeing managers that were reaching for yield or just reaching in exotic securities whether it’s equity or convertibles or even emerging market debt, and a lot of those areas have been having difficulty recently, particularly places like Argentina where bonds fell 50 points overnight. That’s a huge drop for fixed income. And investors are calling us and said, “What do we think about that?” And we’re telling them exactly what you just said.
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