Red flag! Partial inversion of the US yield curve

For professional investors only.

The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF shares and may receive less than the current Net Asset Value per Share when selling them.


Based on past US tightening cycles, the Fed has generally hiked two times after the yield curve inverted and the recession happened between 12 to 24 months after the inversion. The Fed’s challenge is to find the right balance between keeping the economy running at potential and anticipating the build-up of financial vulnerabilities.


The US Treasury yield curve partially inverted on Monday 3 December when the interest rate on 5-year Treasury bonds moved below the rate on 3-year bonds (5y-3y yield spread dropped to -0.02 percentage points). All eyes are now on the US yield curve because such an inversion has been an indicator of the timing of the past two economic recessions in the US.

For investors, the timing around de-risking portfolios is a trade-off between forfeiting upside potential and playing safe. In the past, traditionally safe assets like gold and bonds have outperformed equities following yield curve inversions. Since 1988, US investment grade corporate bonds averaged an annualised rate of return of 6.4%, while the S&P 500 index declined 4.1% in the two years following an inversion of the yield curve, based on the 10-year Treasury bond yield compared with the yield on 2-year notes. In addition, equity volatility rose significantly in these time periods, by 38% on average one year after the inversion.

 

 

Opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.