Interest Rates: The yield curve conundrum

Brendalee Scott-Novak, Butterfield

Brendalee Scott-Novak, Butterfield

The treasury yield curve has garnered much interest in the news recently. The past few weeks have witnessed a narrowing of the gap between short- and long-term rates dangerously approaching a proverbial inversion. So what is a treasury yield curve? As an investor, why should it matter?

Commonly known as the term structure of interest rates, Investopedia describes the treasury yield curves as the relationship between yields and maturities of on-the-run treasury securities. Frequently used as a benchmark for various types of debts, including mortgage and bank lending rates, it is considered an important indicator of rate changes and future economic activities.

A treasury yield curve has three shapes: normal, flat and inverted. A normal curve is upward sloping and exists when longer maturity bonds offer a higher yield compared to a shorter maturity. This type of curve signifies the expansionary phase in an economy. With a flat curve, there is little difference between short and long-term rates. This typically occurs during the transition between a normal and inverted curve and signifies investors are worried about the future economy. Conversely, an inverted yield curve, the most uncommon of the three curves, is downward sloping and exists when shorter maturity bonds offer a higher yield versus longer bonds. This type of curve not only signifies a lack of confidence in the future economy but is typically considered a reliable predictor of future recessions.

With the Federal Open Market Committee (FOMC) of the U.S. Federal Reserve actively increasing the Fed funds rate, are they supportive of an inverted yield curve?

Following the credit crisis of 2008, global central banks embarked on various quantitative easing measures. The purchase of record amounts of long-term debt pushed longer-term yields down, even as short-term rates remain firmly anchored at zero. As the U.S. economy recovers at a moderate pace, the Federal Reserve is increasing the Fed funds rate. A recent study by the Federal Reserve Bank of San Francisco found that movements in the Fed funds rate over the last 30 years have been closely related to movements in short-term rates but with much less impact on longer-term rates. It could, therefore, be inferred that while the current round of rate hikes has predominantly impacted the shorter end of the curve, quantitative easing along with other factors was successful in synthetically keeping long-term rates low, resulting in a flat yield curve. But would the FOMC engage in policy tactics that would deliberately push short-term rates up even as the long-term neutral rates remain range bound?

The Fed’s dual policy mandate is the driving force behind creating stability (drive down long-term rates), and to ward off inflation (by increasing the Fed funds rate). An inverted yield curve is merely the corollary of both actions interacting over time. Although the study found that an inverted yield curve proceeded every U.S. recession in the last 60 years with one exception, is it possible that, given years of easy money policy, an inverted curve may not be all that bad?

One of the arguments supporting a possible subdued environment is that the wrong proxy is being applied to determine bank funding. While the 10-year U.S. treasury is considered a good proxy for long-term rates, the two-year treasury may not be the appropriate measure for short-term bank funding. The spread between the three-month Treasury bill or Fed funds rate at 75 basis points and 96 basis points, respectively, is considered a more reliable measure versus 28 basis points for the two-year treasury.

Another argument supporting a tepid inverted curve environment is the length of time between an inverted curve and a recession. According to the Federal Reserve Bank of Cleveland, the average recession occurs about a year following an inversion, allowing the economy to grow for several months. Short-term rates have admittedly been truncated at unprecedented lows, even as the economy experienced strong growth. Supporters in this camp tend to focus on the level of the spread versus the inverted curve per se. As global central banks such as the Bank of Japan and the European Central Bank continue their monetary easing, rates at the longer end of the curve will continue to face pressure of synthetically low yields.

Given these crosswinds, will long-term rates remain anchored even as short-term rates increase? Or will rates move in tandem and maintain a flat yield curve? More importantly for investors, what can you do to protect your portfolio in either scenario?

Participating in the shorter end of the curve appears to be one of the safest plays. Maintaining duration of two years has yielded a small but positive returns every year dating back to 1988 according to the ICE Bank of America Merrill Lynch current two-year U.S. Treasury Index. With the Fed’s current trajectory of increasing rates gradually, potential losses from a short duration portfolio may be tempered. Exposure to floating rate notes or “floaters” is another attractive option for investors in a rising rate environment. Because coupons adjust periodically based on short-term benchmarks, floaters respond quickly to changes in the Fed funds rate. Issued by both government-sponsored enterprises (GSEs) and investment grade companies, they take the form of non-callable or callable bonds. Floaters exhibit a positive correlation to high yield bonds and equities and can add diversification and potentially improved risk adjusted return to your portfolio. The coupon reset feature also reduces the price sensitivity of floaters to rates movements. Floaters, however, have credit risk and do not provide the same level of protection as cash in downward market cycles.

With short and long-term yields converging around the 3-percent milestone, investors will undoubtedly face a tough call. Whether the yield curve inverts, or continues to flatten, now may be an opportune time to align your investment strategy with your investment goals and risk profile.

Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.

Statistics and Data Source: Bloomberg LP., Bureau of Economic Analysis, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Cleveland,  Federal Reserve Bank of San Francisco, BCA Research