Chart of the Month – Credit investors: beware of the re-steepening

Credit investors: beware of the re-steepening

The slope of the US yield curve, which can be illustrated among other examples, by the difference between the US 10-year yield and the US 2-year yield has been widely used as an early indicator of recessions. Its normal slope should be positive, which means fixed income investors should be rewarded with a higher yield for buying bonds with longer maturities because, among other things, they sacrifice visibility on future inflation path and economic activity.

In the past, however, the yield curve has inverted various times between the 10-year and 2-year maturities. Some of those times include 1929, 1974 and 2008, where the inversion lasted particularly long and was followed by some well-known turbulences in the market.

The reason for these turbulences can be explained as follow: as the economy is slowing down, inflation is falling and unemployment starts rising, the market anticipates that the FED will have to cut rates to avoid a recession and to protect the labor market. Although the long-term part of the curve tends to move lower on the prospect of slower economic growth, the front end is much more reactive in reflecting the expected rate cuts from the FED. This mechanism creates what we call a bull steepening of the yield curve, where the 2-year yield drops faster than the 10-year yield.

The impact on credit spreads (a gauge of credit risk) is usually negative as we normally see a flight to safety during these periods of stress, where investors will favor quality over speculative assets, in other words, investment grade over high yield.

Over the last 30 years, as seen on the chart of this month, such occurrences also included the dot com bubble and the Covid pandemic. The shaded rectangles represent the period from the lowest point in the yield curve slope (in blue) and its highest point in the cycle. The dotted blue line is the frontier where the curve becomes inverted or positive again. We can see that credit spreads (in orange) have spiked in each of these periods to a cycle high.

Contrarily to a common misconception, it is not so much the yield curve inversion that coincides with spikes in credit spreads, but rather the re-steepening following these inversions. If we take the global financial crisis, for example, we can see that the yield curve started to invert in late 2005 already, without triggering any widening in credit spreads. It is only in the summer of 2007 (a few months after the curve hit the bottom and started rebounding) that the spreads spiked from a low of 240bps to a frightening high of 1’830bps.

As we can see in the chart, the yield curve has been inverted for more than 2 years in this cycle and has now re-steepened an impressive 124bps.

Today, credit spreads have remained muted and are below their historical average (the dotted orange line). It is of course not certain that history will repeat itself and that they will spike to new highs, but it is very unlikely that they will remain at such tight levels, especially given the uncertainty stemming from the approaching US elections and the two ongoing conflicts in Ukraine and in the Middle East.

Therefore, in such an environment, one should beware of the re-steepening of the yield curve and favor a higher quality in his or her credit portfolio.

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Chart of the Month – What’s going on?

Chart of the month

What’s going on?

The US yield curve is flattening at a steady pace. One of the most followed indicators, the 2-10 year differential, has more than halved since the beginning of the year, from 125 basis points to less than 60 bps today.

Traditionally, a flattening yield curve is a warning signal for lower economic growth, and in some cases, notably when it gets into negative territory – i.e. an inverted yield curve – for a recession. Although we’re not in that situation, this rapid flattening of the 2-10 year slope raises questions, especially when all lights seem to be flashing green: global economic growth is strong, Europe and Japan show at last real improvements, Emerging Markets and China are roaring ahead, US employment is extremely steady, and the list goes on.

Besides all these positive indicators, it is also noteworthy that, apart from Venezuela or Turkey, there is no imminent catastrophe looming, at least apparently.

So what is the US yield curve telling us or, in other words, is there something we should really worry about?

First of all there are technical reasons for this flattening: the Fed has announced it will raise interest rates as soon as December this year, with further hikes planned next year, which exerts upside pressure on 2 years yield, while at the same time, tame inflation figures tend to put opposite pressure on longer term yields. The fact that the Fed has also declared that QE was now behind us should eventually have increased prospects for higher long term yields, but the Fed was and is not – by far – the only buyer of long dated Treasuries and strong hands have been on a buying spree of late: foreign holdings of US Treasuries have increased by more than $ 300 billion this year, led by China in particular.

Then, in a world craving for yield, getting 2.5% on one of the safest and most liquid assets in the world (the US 10 year T-notes) is clearly attractive. There is almost no equivalent in the developed world, and perhaps the most strikingly comparable comes with Portuguese 10 year yields which barely reach 1.9%!

But let’s not be complacent; most US recessions were preceded by a yield curve inversion with a negative 2-10 year slope. As we get closer to zero, more and more investors will start fretting about a possible recession and become more cautious. Although we’re not in the recession camp as we see no signs of it in today’s markets and economy, we’ll keep on closely following any deterioration in what could be qualified as a Goldilocks environment. For the time being, enjoy strong equity markets, but don’t overlook the possibility that something bad and unpredictable happens….