A flattening yield curve: What has changed since the beginning of 2018?
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A flattening yield curve: What has changed since the beginning of 2018?

This year has definitely not been an easy one for any investor, particularly for those who happened to have just started tapping into the investment arena last January. Apart from the heightened volatility witnessed across the equity segment, the fixed-income segment has also been quite a roller-coaster.

Starting off with the basic definition of yield to maturity (YTM) and the yield curve, we can then better understand the implications, and the different kind of shapes in yield curves we can come across in financial markets. The YTM quoted on a bond is the gross annual return an investor would get should he hold the bond until maturity, and assuming that each and every coupon (interest payments) is reinvested (immediately) at the YTM quoted at the beginning of the period. The yield curve is simply a line plotting the various yields quoted on bonds with a similar credit quality, but with varying maturities. 

By far, government bond yield curves are the most quoted, with the US Treasury yield curve being the most in the headlines – particularly over the past year, seeing how things have evolved as the US Federal Reserve kept quite a steady pace in hiking the benchmark interest rate, at a time of global growth expectations woes. The most popular points on the yield curve usually quoted are the three-month, two-year, five-year, 10-year and 30-year US Treasury debt. These tend to be the benchmark reference rates for bank lending or mortgages. Likewise, the German-Bund in Europe is usually referred to as the benchmark for the eurozone.

A yield curve can have different kinds of shapes throughout various points of the economic cycle, which tend to be used to predict changes with respect to growth and inflation expectations. A normal yield curve is one in which a higher yield is quoted the longer the maturity, compensating for the fact that investors are locking in their investment for longer.

A scenario where shorter-dated yields are higher than longer-dated ones is synonymous with an economic environment where investors are expecting a recession – called an inverted yield curve. The most popular spread quoted along the yield curve is the two-year and 10-year, as well as the three-month and 10-year spreads. On the left-hand side of the curve, more control can be exercised directly by the US Federal Reserve through its monetary policy decisions.

At the beginning of 2018, the Fed funds rate was set at a range of 1.25 to 1.50 per cent, following which three rate increases have taken place since then, to a range of two to 2.25 per cent last September. The majority of Fed officials seemed to be still in favour of another hike next week, albeit retaliations from President Donald Trump instigating that Fed chairman Jerome Powell is making a big mistake in raising interest rates.

A yield curve can have different kinds of shapes throughout various points of the economic cycle

Back in January, the spread between the two-year and 10-year yield was hovering around 50 to 60 basis points. However, as rate hikes followed suit, with the two-year yield being among the most sensitive to interest rate changes, the spread shrunk to some 10 basis points during the first week of December. At one point, the spread turned out to be negative when comparing the yield on the five-year note and the two-year note.

Such a scenario was reflecting a number of ongoing factors. On the one side, the US Fed kept on increasing rates and maintained a relatively hawkish tone throughout most of the year – indicating further hikes in the future. On the other hand, the ongoing US-China trade war, inflation expectations and overall global growth slowdown, have all weighed down on investors’ expectations as to whether or not markets have now reached the end of a bull market.

Since the spike in volatility throughout the month of October, which led to extended declines up to the first 10 days of December, markets seem to have lowered their expectations of growth and higher interest rates for longer.

As a result, this led to a flattening yield curve, which can hurt lenders’ profitability and stability.

Theoretically, if no spread is present between short- and long-term rates, minimal growth is expected, or perhaps lenders would demand an even higher premium. In fact, markets are even anticipating that the current Fed’s probability of three rate hikes in 2019 may be lowered to potentially just one.

However, for the bond investor, one should keep in mind that the Federal Reserve’s main goal is to maintain stable prices and avoiding an economic scenario where the economy overheats. Thus, varying expectations between the Fed and the markets will always tend to result in swift movements across the bond and equity markets. An increased level of transparency by the Fed since the last financial crisis has aided in mitigating market surprises. Naturally, market fluctuations and heightened volatility from time to time shall be expected.

At the time of writing, some of the negativity that has been witnessed since the beginning of the month and concerns over the possibility of an inverted yield curve, reversed the course of the situation on the back of renewed optimism that the US and China can secure a trade deal – with a widening spread recorded on the two-year and 10-year notes.

Nevertheless, demand for long-dated bonds seemed to remain buoyant, following a $16 billion 30-year Treasury bond sale last Thursday which was heavily oversubscribed when compared to the recent average – with primary dealers at auction level attaining just 22 per cent, as opposed to 26 per cent in recent auctions. Such strong demand came at a time where interest rate levels hovered around their lowest levels since September. Perhaps investors are still of the opinion that Treasury bond prices are to head higher from here, as interest rates decline.

This article was prepared by Colin Vella, CFA, an investment advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410 or e-mail colin.vella@jesmondmizzi.com.

www.jesmondmizzi.com

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