FIXED INCOME STRATEGY

The flattening that really matters

Aug 16, 2018

The flattening U.S. yield curve is in the spotlight. Is the curve set to invert – and foreshadow a recession as it often has in the past? We explain why comparisons with past flattening episodes may be a case of apples and oranges. And we argue that when it comes to flattening, investors are focused on the wrong curve: It is the flattening in return expectations between low- and high-risk assets that really matters.

Fixed income highlights

  • We caution against comparing the shape of today’s U.S. Treasury yield curve to the past and using it as a recessionary signal in isolation. Post-crisis ultra-easy monetary policies, a structural rise in risk aversion, and the run-off of maturing bonds on the Federal Reserve’s crisis-era balance sheet may make the slope of the yield curve less informative than it has been historically, we believe.
  • We highlight a simple historical relationship between the slope of the U.S. yield curve and the “unemployment gap” – a measure of labor market slack. Both have dropped to multi-year lows, consistent with their historical behavior in the latter stage of economic cycles. This argues for building resilience into portfolios.
  • The flattening that really matters, in our view, is the one taking place in the securities market line (SML). This shows the risk-return tradeoff across assets. Expected returns on lower-risk assets have risen alongside the Fed’s policy rates, reducing the need to stretch for yield into higher-risk sectors. This has triggered volatility in the fixed income market – and underpins our defensive stance: a preference for U.S. short duration and higher-quality credit.

Snapshot

What’s the flattening SML telling us? The two SMLs represent the yields of the broad fixed income market, adjusted for risk, for 2012 – in the midst of the Fed’s quantitative easing campaign – and 2018. The 2018 trend line (green) is much flatter than the 2012 trend line (blue), as yields on lower-risk assets such as the U.S. Treasuries have significantly increased alongside rising U.S. interest rates. In some cases the volatility of higher-risk assets has climbed, while their yields have fallen (see global ex-U.S. bonds). The result: A flattening of return expectations across the risk spectrum that means investors today have far less incentive to stretch for yield. See the chart The other kind of flattening.

The other kind of flattening
Jeffrey Rosenberg
Chief Fixed Income Strategist
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views ...