Yield Curve Inversion Has Investors In A Tizzy

THE 2-10’S INVERTED

The markets sold off early this week because of concerns over an inverted yield curve. Despite much of the yield curve having been inverted for months, 2-10’s inverted for the first time since 2007 and financial media decided to propagate this narrative. Let’s be clear – the fixed income market has been flashing warning signs for much of the year and the marginal difference between 10 basis points of steepness and a barely-inverted yield curve is negligible. We have been advocates of defensive positioning since the Spring, but don’t advise overreacting to the last 10 bps of flattening and do not recommend chasing duration after this dynamic move lower in yields. It is a warning sign, yes, and investors should probably take a look at their overall allocations and not be overweight risk assets – a marginal underweight may even be appropriate.

IS IT DIFFERENT THIS TIME? MAYBE.

The current inversion exhibits some different characteristics from past occurrences. First, typical inversions stem from the Federal Reserve increasing short-term rates (what we often call a Bear Flattener). This inversion stems from strong inflows into the long-end of the curve (Bull Flattener) which I believe stems from a number of reasons. The U.S. economy is an island of strength in an otherwise dreary macroenvironment. As such, our yields are higher than most developed nations, and Central Banks across the world have systemically hurt their economies through negative rates. So much so, that pension funds and other institutional investors are now taking on currency risk and buying our treasuries outright. Second, there was still significant short interest in treasury futures. And finally, as yields have fallen, more mortgage exposure has been called away and this is being replaced with treasury exposure. When yields have this sort of dynamic move, mortgage investors are often forced to buy treasuries because their portfolio duration plummets (negative convexity). Hence, the flood into the long-end of the curve. I do not believe the most recent move in treasuries is an indication of extreme economic weakness in the United States, but rather a perfect storm of the above influences. This sort of move can have a mind of its own, and I do not know where it stops (although my feeling is that we are close). Ultimately, I think this long-duration trade ends in tears and there is significant vulnerability at the long-end of the curve. 

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Disclosure: This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. ...

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