The yield curve has been injecting fear into markets all year. Investors understandably panicked when the spreads between short-term and long-term Treasuries bonds inverted a few weeks ago. However, investors have been looking at the yield curve with the wrong lens, argues Barron’s. If you actually pay attention to what has been happening recently, you will see a distinct picture of spreads rising, which is a very bullish indicator. Moving averages on the spreads have been growing, the first instance of such in a long time. A number of macro factors are supportive of wider spreads, including a now dovish Fed and strongly rising oil prices, which have injected more fear of inflation.
FINSUM: We think spreads are headed in the right direction. Taken as a whole, the market is starting to look like a good buying opportunity right now. It seems odd to say given stocks are at an all-time high, but if you look at the back drop, the situation looks pretty bullish.
Investors have been very worried about the yield curve’s recent inversion, and with good reason—an inversion is the most reliable indicator of a forthcoming recession. That said, there are two important factors to note. The first, of which most readers will be aware, is that it takes an average of 18 months for a recession to arrive once the curve inverts. However, the second factor, which is less well understood, is that the specific pairing of yield curves that are inverted also makes a difference. The media and market have been totally focused on how the 3-month and ten-year yield has inverted, but the best indicator historically has been the two-year and ten-year, which is still 18 basis points or so shy of an inversion.
FINSUM: The signal from the 2- and 10-year pairing has been a much better indicator. Accordingly, the inversion the market has been obsessing about may be less relevant.
What is the biggest short-term risk to markets? Is it a recession, China trade relations, and EU meltdown? None of the above. Rather, it is the upside risk of better economic data. A short burst of good US economic data, and the resulting comments from the Fed, could send US bond markets into a tailspin after the huge rallies of the last several weeks. The market for long-term Treasuries looks overbought, which means a reversal in economic data could bring a lot of volatility which could even whiplash equities.
FINSUM: At this point, a round of good economic data, and a stray hawkish comment from the Fed, would deeply wound bonds and hurt equities too (because everyone would again grow fearful of hikes).
We don’t want to say that we told you so, but we have been broadcasting that bond markets had overreacted to the Fed’s change of tune. This week, bond investors have started to correct themselves as yields on the ten-year have jumped considerably on better economic news. With that in mind, limiting rate risk on bond holdings has taken on renewed importance. Accordingly, where better to be that in short-term, less rate-sensitive, bond funds. For options here, take a look at the Vanguard Short-Term Bond ETF (BSV), yielding 2.8%, and the PIMCO Enhance Short Maturity Active ETF (MINT), yielding almost 3%.
FINSUM: We think there could be some significant yield volatility in the next few months, and therefore feel it is best to stay rate hedged/defensive.
The yield curve is the center of attention right now. The short end is yielding more than the long end, everything feels upside down. So how to play it? Yields on long-term bonds have fallen so steeply that it seems foolish to think they will continue to do so. Inflation is still around and the Fed still has a goal to get the country to 2%, which means yields seems more likely to rise than fall (unless you think a recession is imminent). Accordingly, there are two ways to play this curve. The first is to use a “bullet” strategy by buying only intermediate term bonds, which tend to do well when the yield curve steepens, especially if short-term rates actually fall. For this approach, check out the iPath U.S. Treasury Steepener ETN (STPP). The other option is to remain agnostic as to direction, buying something like the iShares Core U.S. Aggregate Bond fund (AGG).
FINSUM: Our own view is that we are not headed into an immediate recession, and thus the long end of the curve looks overbought.