Don’t Forget this Important Fact about the Yield Curve

Matt Toms

Matt Toms, CFA

Chief Investment Officer, Fixed Income

Investors are asking why rates are so low and how much lower they might fall; better to ask whether low rates are still effective.

The yield curve regained the limelight in August when yields on ten-year Treasury notes dipped below yields on two-year notes, the dreaded “inversion” that caused markets to sell off. Remember, an inverted yield curve represents fear of a recession; it does not cause a recession. This is easy to forget amid headlines reminding us that a yield curve inversion has preceded every U.S. recession since 1950, which is true. However, it is also true that it can take almost three years for a recession to take hold after the yield curve inverts. That’s like telling a doctor you think you might be sick some time in the next three years. The doctor is likely to ignore you and simply proceed with the examination.

So how healthy is the U.S. economy? Fundamentals remain underpinned by continued strength from the U.S. consumer and the likelihood of accommodative policy from the Federal Reserve. Increasingly dovish Fed policy brings us to the next question on investors’ minds: With rates so low, how much lower can they go? We think a better approach to the question is, are low interest rates still effective? Our view is that certain parts of the global economy have built up an immunity to low interest rates as a remedy for economic malaise, specifically those parts of the world such as Europe and Japan where their yields are decidedly negative. This means their central banks will have to keep rates lower for longer than historical averages.

Accordingly, we expect fiscal policy to play a role to stoke growth, lessening the probability of recession. We will be watching fiscal spending closely, as we believe growth projects that increase productive capacity, e.g. infrastructure spending, are more effective and should alleviate investor concerns about growing government budget deficits.

Returns, Spreads and Yields
Returns, Spreads and Yields

Source: Bloomberg, JPMorgan,. All spreads are to U.S. Treasurys and are option-adjusted except for emerging markets, which are nominal. All returns are total returns including dividends, expressed as percentages, in U.S. dollars.

Bond Market Outlook

Global Rates: U.S. rates remain lower, Federal Reserve likely to cut in September

Global Currencies: U.S. dollar gains against developed market currencies, hurts emerging market currencies

Investment Grade: Higher U.S. yields relative to global rate levels attracting non-U.S. investors

High Yield: Low nominal yields limit opportunities; further spread tightening to be driven by lower rated CCCs or energy sector

Securitized: Lower financing rates should provide a near-term tailwind for housing but not necessarily agency mortgage bonds

Emerging Markets: The EM-DM growth differential will increase as DM growth continues to soften

Sector Outlooks

Global Rates and Currencies

How low can rates go? The recent rally in U.S. Treasurys reflects foreign buying of U.S. assets, which still carry positive nominal yields; it also reflects the yield curve, which is telling us investors do not believe rate cuts will help the U.S. economy. We disagree; mortgage refinancing has the potential to support U.S. consumers. Nonetheless, many investors are beginning to take seriously the possibility of negative rates in the United States. We believe the probability of negative rates in the U.S. is low, predicated by the solid economic backdrop and by our expectations that the Fed will continue to cut rates modestly, taking the Fed Funds rate to 1.5%. We think the two-year yield will continue to decline modestly, while the ten-year yield will hover around 1.5%.

Holding the 10-year yield below 1.5% would require ongoing stress to the U.S. economy, a scenario we believe is unlikely. In our view, fiscal stimulus in Europe will be more impactful than additional monetary policy stimulus. While the European Central Bank (ECB) will likely cut rates again, another 10 basis points will not provide much benefit. Rumors of a €51 billion stimulus package from Germany could overturn the negative view that extends beyond the visible horizon.

Investment Grade (IG) Corporates

IG spreads sold off in August, as the trade war began to affect global economic growth and heighten the concerns of a U.S. recession. Yet IG-specific metrics continued to show strength, with 2Q19 earnings a touch better than expected and negative rates in overseas markets boosting demand for U.S. credit. With negative yields now on about $17 trillion of global bonds, U.S. IG should remain attractive to yield-seekers. New issue supply was a bit lower than expected, setting the stage for an active September. Given the current balance of risks in the market, we think spread upside potential is limited.

High Yield (HY) Corporates

August saw continued outperformance for higher rated tranches, with BB-rated credits adding to their lead and CCC-rated credits falling further behind. The rally in Treasurys continued to support BBs along as spreads held steady. At current levels, BB- and B-rated spreads seem tapped out but could grind tighter if rates decline and the economy does not falter. A turnaround in trade rhetoric seems the most obvious catalyst for risk appetites.

Securitized Assets

Agency residential mortgage-backed securities (RMBS) materially underperformed Treasurys as flight to quality emerged and interest-rate volatility surged. Nominal spread levels remain attractive versus rates and credit, and should soften the impact of elevated supply.

We retain our positive tactical outlook for non-agency residential mortgage-backed securities (RMBS), as spread levels still imply a risk-adjusted, relative-value advantage over alternatives. We believe expectations for faster prepays will foster spread tightening pressure for much of the universe.

We retain our positive outlook for commercial mortgage-backed securities (CMBS), as attractive yields likely will support continued demand following August outperformance. We do not think the new issue pipeline is daunting, particularly since CMBS continue to offer attractive spreads and riskadjusted yields.

The outlook for asset-backed securities (ABS) remains a function of broader risk sentiment, offering outperformance potential when market beta is negative and vice versa. While questions loom around subprime borrowers, U.S. consumers generally are on solid footing.

Emerging Market (EM) Debt

EM has been tethered to the fortunes (and misfortunes) of US-China trade talks. The sector was further disrupted by the unexpected election results in Argentina, underscoring the impact politics can have on idiosyncratic risk. While volatility is likely to persist, we expect the EM-DM growth differential will start to increase in 2H19 to 2020 as DM growth continues to soften.

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Past performance does not guarantee future results.

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