Volatility has been more subdued in recent weeks, as has the commodity complex, while bond yields and equity markets have continued to grind higher. The war in Ukraine has now moved into its second month. Some reports have suggested that Russia has begun to narrow its focus to the Eastern regions of Ukraine. It is too early to confirm whether that is indeed the case. Nevertheless, the prospects of a conflict that may be turning a bit more targeted, may have contributed to the market action of late, which has been less turbulent than what was witnessed a month ago. Below, we discuss the U.S. yield curve, which has received an excessive amount of attention by most major financial news outlets.
What exactly is the “yield curve”? It can be thought of as a series of expected returns for government bonds with various different maturities. There are yields for short-term government bonds that mature in a few months for example. There are also yields for longer-term bonds that mature in ten years, or even longer. The yield curve is simply a line that links all of these various yields together.
An upward sloping curve suggests investors are willing to accept a lower return for bonds that are shorter-term, while demanding a higher return for longer-term bonds to compensate for the extended holding period. In reality, the shape of the curve can, and often does change, because bond yields are determined by investor expectations. More specifically, it’s possible for shorter-term yields to be driven higher or lower, while longer-term yields may move to a lesser extent or even in the opposite direction.
The dynamic explained above has taken place to some extent in recent months. Investors have been preparing for central banks to raise interest rates quite aggressively. As a result, short-term bond yields have moved sharply higher. Meanwhile, longer-term bond yields have risen less dramatically of late, as they are being influenced by concerns around whether central banks could raise interest rates too far, resulting in more restrictive financial conditions that could eventually present headwinds to economic growth. This divergence over the past few months has resulted in a flattening of the yield curve, and in some cases, an outright inversion where longer-term bond yields have fallen below shorter-term yields.
Why all the fuss over the yield curve? An inversion of the U.S. curve has proven to be a useful signal that a U.S. recession may lie ahead. But, as with most issues in investing, there is significant nuance that needs to be considered. First, there are different yield curves depending on the maturities being analyzed. Some of the other yield curves are still upward sloping, suggesting recession risks remain relatively benign. Furthermore, there can be a significant lag, often well more than a year, between a yield curve inversion and a recession. Moreover, the U.S. Federal Reserve is expected to begin selling bonds in the not too distant future as part of its plan to unwind one of its programs put in place in 2020 to address the pandemic-induced recession. Those bond sales could add upward pressure to longer-term bond yields, and potentially unwind some of the flattening of the curve that has taken place.
Our firm’s broader investment team regularly reviews and publishes a U.S. recession scorecard which consists of seven different indicators, including the yield curve. To-date, none of these have flashed warning signs this cycle, giving us confidence that it remains premature to be too concerned about the risks of a recession. Nevertheless, these indicators can, and will change, over time. For that reason, we continue to be attentive.
Should you have any questions, please feel free to reach out.
Have a great weekend.