EC Finding A Sweet Spot On A Flat Yield Curve

Over the past 16 months, our yield curve has gyrated more than Chubby Checker—your King of Twist—at a Saturday night kegger. Just take a gander at the chart below. The red curve depicts the normal Treasury debt market extant on the eve of last year’s Independence Day. One year later, things went topsy turvy, resulting in the inversion depicted by the blue line.

And now? Well, now we’ve got a flat curve with very little variance in rates stretching from one-month bills to five-year notes (see the green line).

(Click on image to enlarge)

zig-treasury-yield-curve.png

So, what happened?

Let’s step back a bit. An inversion of the yield curve is usually taken as a signal of an impending recession. Not an immediate downturn, mind you, but 12 to 18 months after the flip occurs. If you accept that reasoning, it seems that the current flattening of the yield curve heralds diminution in fears of an upcoming slump. Not all is beer and skittles, however. Historically, a horizontal front end in the yield curve portends low growth ahead.

Slow growth is certainly better than negative growth, but this presents a challenge for portfolio managers looking to diversify stock risk. Many might be tempted to swing for the fences, aiming to obtain the highest possible yield as recompense for sluggish stock performance. Reaching for yield typically means stretching out to acquire longer-dated paper but that may present untenable risks for conservative investors or those who need to preserve capital. And that’s reason enough to consider intermediate-term bonds or bond funds.

To understand why this approach may make better portfolio sense, consider the difference in rate volatility across segments of the curve. Look back at the chart above. Between July 2018 and November 2019, the greatest swing in rates occurred in intermediate-term paper. The question now is whether the curve’s midsection has reverted to normal, heralding a relatively stable rate environment going forward, or is likely to rebound.

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Disclosure: None.

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