Deeper into inversion, preparing for a steepening
Author: Luca Manera, CFA, Investment Manager
Geneva, 27 February 2023
In 2022, the FED embarked on the fastest hiking cycle to battle soaring inflation as it peaked towards 10%. The persistence in core-CPI, the tightest labour market and record high wage growth has forced the FED to increase rates to 4.5% from historically low levels. Bond yields anticipated and reflected the FED’s hiking cycle by pushing treasury yields higher. However, the jump in yields has been uneven such that short-term yields jumped by more, prompting the US yield curve to invert. Yield curve inversions do not happen often, over the past 40 years it has occurred only 5 times during the early 80s, 1989, 2000, 2006 and in 2022-2023. Historically, following a curve inversion the US economy enters a recession, which in turn leads to falling bond yields.
Investors should prepare for what (eventually) follows, that is a steeper curve. The “steepening” can offer investors an attractive opportunity to generate absolute and risk-adjusted returns without the need to take additional credit risk. We look back in history to assess whether long-only managers should focus on the short, long or barbell across the US treasury curve and how to position with green bonds.
Deeper into inversion: The US curve continues to invert further as short-term yields rise faster than long-term yields
Source: Bloomberg, St. Louis FED, Asteria Obviam
A resilient economy and extended inversion
To the surprise of many, including us, the US economy is holding up better than expected in spite of a jump in the probability of recession to 65%; the consumer remains resilient, the labor market is strong and inflation has been falling faster than expected. In addition, financial conditions have improved meaningfully from the lows of last year. This creates a conundrum for the FED if they have tightened sufficiently into restrictive territory or more hikes are needed. As a result, the US yield curve can continue to remain inverted from already extreme levels if the economy continues to be resilient.
Preparing for a curve steepening
Despite the strength of the economy, market participants are expecting the curve to flatten by year end and steepen in 2024. According to Bloomberg estimates the 2-year bond yield is forecasted at 3.9%, the10-year bond yield at 3.4%. This is a significant decline in yields and a first step towards a steeper curve in 2024. Historically, the average slope of the curve is of 88bps and the current level of inversion is extreme compared to data compiled since 1976.
Investors expect the curve to start steepening heading into 2024
Source: Bloomberg, Asteria Obviam
Looking back over the past 20years, a bull-steepening occurs after a curve inversion as front-end yields fall faster than long-term yields, pushing bond prices higher. The steepening cycle can last several quarters such as in the 2000s or during the great financial crisis, the only exception has been in 2019-2021 where the steepening was cut short during the COVID-19 pandemic.
Preparing for a bull steepner
Source: ICE Index, Asteria Obviam
How to position for falling yields and a bull-steepening:
We take the ICE Index US sovereign yield curves from December 1999 and compute the performance of 3, 6 and 12-month rolling portfolios for the 2-year,10-year treasury bond and a barbell (50/50), at every month-end when the curve is inverted. This naïve assumption reflects the view that timing for a steepening can be challenging as flat/inverted curves can extend depending on the macro-economic and monetary policy outlook. Portfolio managers should prepare to take advantage of a possible bull steepening and position their portfolios depending on their objective of absolute or risk-adjusted returns.
Summary of monthly rolling portfolios when the curve is inverted, since December 1999
We find three takeaways for investors, the first is that a short-term holding period of 3-months does not reward investors hoping for a “quick trade”. This supports the fact that the curve can remain inverted for a prolonged period, and impact negatively returns, especially for long-tenor (volatile) bonds. Such as during the summer of 2022, where the curve continued to invert and holding 10-year bonds generated significant losses. The second finding is that to generate attractive risk-adjusted returns, investors should focus on short-term treasury bonds. As volatility remains constant at around 2%, while the return distribution is skewed to the upside. Finally, bond managers looking for an absolute return can benefit from a barbell approach over a 12-month horizon thanks to the lower volatility of short-term bonds and higher absolute returns from longer dated bonds. This approach can reduce the minimum loss and benefit from double-digit return.
Positioning with green bonds
While the US Treasury has not launched a sovereign green bond program yet, bond investors can capture the bull steepening by investing in green bonds. This can be done through issuers that closely correlate with treasury returns, such as AAA-rated quasi-agency bonds. There is currently $66billion of quasi-agency green bonds in the ICE Global Green Bond index of which 40% in AAA rated bonds, $9billion issued by German and Dutch related issuers and $14billion from AAA-rated Asia Development Bank.
Not if, but when
The economic outlook remains uncertain, investors are pricing rate cuts heading into 2024 and a steeper curve, while the FED remains firm to keep interest rates high for a prolonged period until it sees evidence of inflation falling towards its 2% objective. In any case, short-end interest rates are poised to fall as the economy falls into recession or the FED cuts interest rates. As a result, bond investors should prepare to position their portfolios to capture this opportunity that historically has offered attractive risk-adjusted returns.