investment insights
Evaluating a changing US yield curve and its implications
Key takeaways
- The start of the Federal Reserve’s interest rate-cutting cycle should trigger a steepening of the yield curve
- We expect this normalising of the yield curve to reflect a disinflationary slowdown rather than a sharp growth downturn. Equities and bonds would both do well
- The main risk to our scenario is a recession. In this case, sovereign bonds would be the main beneficiary. Should inflationary risk prevail instead, we would expect more support for stocks over bonds
- Our base case economic scenario remains for a soft landing; we maintain global portfolio equity and bond allocations in line with our strategic benchmarks.
As we approach the start of a Federal Reserve (Fed) easing cycle, investors should anticipate a further steepening in the US Treasury yield curve. This should result in the curve returning to a normal configuration, but without the recession that such a normalisation has traditionally prefigured.
The yield curve illustrates the relationship between bond yields of different maturities, typically 2-year versus 10-year maturities. Economic and financial forces influence and shape the yield curve and help explain its importance when assessing financial markets and investments. Normally, the difference between short and long-dated bond yields widens as maturities lengthen, as investors demand compensation, via higher yields, for locking away their cash for longer. An inversion of the yield curve, where short-maturity bonds offer higher yields than longer-dated ones, has been an historically reliable precursor of US recession, although the most recent inversion has cast some doubt on this. Today, the yield curve is returning to a normal configuration after having been inverted for more than two years. What does this mean for investors?
Yield curves can normalise in a couple of ways. A ‘bear steepening,’ where long-term yields rise faster than short-term yields, often reflects expectations of stronger economic growth and/or higher inflation. Conversely, a ‘bull steepening,’ when short-term rates drop faster than long-term rates, typically happens when the central bank cuts policy rates in response to economic weakness and/or disinflation, as is the case today. The Fed rate cutting cycles of 1990, 2000, 2008 and 2020 were all accompanied by a recession and significant bull steepening of the yield curve (multiple percentage points), in other words, the sharp fall of short-dated versus longer-term yields.
Not all bull steepenings are equal, however. Episodes that did not end in recession only saw an average reduction of 70 basis points (bps) over the rate-cutting cycle, resulting in a more moderate steepening of the yield curve. These instances were arguably rarer – only three have occurred since 1987.
Resolving the uncertainty around whether the US economy will experience a recession or not will have implications for the yield curve. How will the yield curve evolve, what are the risks to our main scenario, and what are the broader asset class implications?
Our base case
Currently, the spread between 2-year and 10-year US Treasuries is around zero. Our forecasts suggest the Fed funds rate will reach 3.50% in 12 months, representing a cumulative 200 bps of cuts. We anticipate that the 2-year Treasury yield will approach 3.60%, while the 10-year yield should move closer to 3.90% over the same timeframe. Given these projections, we expect the yield curve to moderately steepen from here and increase by about 30 bps from current levels. Our projected steepening is in line with our expectation of a soft economic landing. How would fixed income and equity markets perform in this base case scenario?
In our base case of a soft-landing, high quality credit would fare relatively well, with a slightly stronger performance compared with US Treasuries, while US high yield bonds would trail slightly. Chart 2 explores how different US fixed income segments have performed historically in different scenarios. High quality credit indices typically hold longer average maturity bonds compared with high yield indices, and thus tend to benefit more from the lower rate environment. However, the performance discrepancies are arguably small.
Equity markets have also generally outperformed their historical average in a soft-landing scenario, with large cap indices and the broader S&P 500 index doing only marginally better than small capitalisations. These results are broadly consistent with a neutral portfolio positioning – and in line with our strategic benchmarks.
What about alternative scenarios?
In the case of recession, US Treasuries unsurprisingly outperform both their own historical average and the other credit segments, as recessionary environments are typically accompanied by a widening of credit spreads for high yield segments in particular, which have lower credit ratings. Equities also underperform their historical average returns in this environment, and cyclical stocks, which tend to be more correlated to the economic cycle, suffer comparatively more than defensive ones. Recessionary ‘bull steepening’ episodes thus undeniably favour US Treasuries over credit, and especially over equities, making Treasuries a valuable portfolio diversifier and hedge.
Finally, it is worth examining scenarios where the yield curve steepens because longer-maturity bonds have risen more sharply, usually in the expectation of higher inflation and/or higher growth ahead. In our recent CIO Office Viewpoint examining US election implications, we argued that if Donald Trump were re-elected as president, growth and inflation would probably turn higher, resulting in less Fed policy easing and potentially widening fiscal deficits. We would expect these risks to generate a form of a bear steepening. Moreover, US fiscal risks and rising risk premia could occur whether Mr Trump is re-elected or not, given concerns over the financing of US policies. Inflationary pressures could also temporarily emerge because of an oil price shock, perhaps owing to an escalation of conflict in the Middle East. These risks would arguably raise the premium demanded by investors to hold longer-term debt and generate upward pressure on long-dated yields.
In such circumstances, nominal sovereign bonds experience lower returns, reflecting increased inflation expectations and concerns over growth that lead to lower demand for longer maturity bonds. High quality credit also tends to suffer more than high yield credit in this context, because of the lower demand for longer maturities, which typically dominate in higher quality credit indices. High-yield corporate bonds outperform as the economic outlook improves, reducing default risk and boosting riskier assets. Equities tend to perform better than average, with both small capitalisations and cyclical assets tending to outperform as the outlook improves and/or consumer price inflation increases. In such an environment, equities should be favoured over bonds, and high yield over high quality credit and US Treasuries.
Balancing risk scenario strategies
While US Treasuries can provide an effective cushion against the risk of sharper-than-expected disinflation and recessionary risks, these will be less effective in portfolios in the case of sharper-than-anticipated inflation. For conservative fixed income investors who are concerned about these risks, balancing nominal Treasury positions with Treasury inflation-protected securities (TIPS), or commodities like gold, can offer a broader shield against rising inflation and geopolitical uncertainty. Historical data supports this, with TIPS outperforming nominal Treasuries during periods of rising inflation expectations, such as in the early 2000s and following the Great Financial Crisis. High real interest rates (rates that strip out inflation, currently slightly below 2% on 10-year maturities) also make TIPS an attractive portfolio diversifier.
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