FIXED INCOME STRATEGY

The flattening that really matters

16/aug/2018
By Jeffrey Rosenberg

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.

fixed-income-securities-market-line-chart

Past performance is not a reliable indicator of future results. Indexes are unmanaged. It is not possible to invest directly in an index. Source: BlackRock Investment Institute based on data from Bloomberg, July 2018. Notes: the chart shows the relationship between the yield and realised volatility of various fixed income assets in December 2012 and July 2018, periods when the “risk-free” rate differed. We use one-year realised total return volatility as a proxy for risk, and yield as a proxy for expected returns. We use the U.S. one-year overnight indexed swap (OIS) rate as a proxy for the “risk-free” rate, and assume zero volatility in this “risk-free” rate. We use Bloomberg Barclays indexes for all asset classes represented, except for U.S.-dollar emerging market debt, for which we use the J.P. Morgan EMBI Global Diversified Index.

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Chief Fixed Income Strategist, BlackRock Investment Institute
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views.

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