by Christoph Schon, CFA, CIPM
Fears of an impending yield curve inversion—usually a harbinger of economic downturn—have been somewhat mitigated thanks to the recent downward revision of rate forecasts by a number of Federal Open Market Committee members. But it’s not entirely risk-off: ongoing political risks and a slowdown of economic activity maintain the pressure on long Treasury yields, keeping the term spread between the 10-year and 2-year rates below 25 basis points.
In our recent whitepaper The Year of the Central Banks, we examined the nine most recent rate hiking cycles of the US Federal Reserve Bank (the Fed), the European Central Bank (ECB) and the Bank of England (BoE) and analyzed the impact on a range of security types in a global multi-asset class portfolio, using the stress-testing capabilities of our Axioma Risk™ analysis platform.
Here are 5 things we identified that investors can look out for in order to prepare for the scenario of an inverted interest rate term structure – and it may not all be bad news:
1. Share prices continuing to rise even as long-term yields fall
Even though every US recession of the past six decades was preceded by a negative term spread, the impact was not felt immediately. For example, after the US 10-year benchmark dropped below the Fed funds rate in March 2000, the stock market continued to rally for another six months. It then took one more quarter before GDP growth eventually went into negative territory. The delay was even longer in 2006, when stocks continued to rise for another year after the initial US curve inversion, and it took a further six months for the recession to set in.
2. Defensive stock (out)performance
What was frequently noticeable in past instances of yield curve inversions was an outperformance of defensive sectors, such as utilities, consumer staples and healthcare, over their cyclical counterparts. This could be observed even when share prices were still rising, although the effect was most pronounced during the run-up to the 2007 recession, as the simulated performance for a choice of Eurozone and UK equity sectors in the infographic below shows.
Simulated sector performance during 2007 curve inversion/flattening
3. The interest rate effect: widening credit spreads as sovereign yields decline
Another common feature of past curve inversions was an early widening of corporate bond risk premia. Commonly, one would expect credit spreads to move in the opposite direction of the stock market. When the economy does well, share prices rise and the yield premium that corporates have to pay over sovereign debt will decline. Conversely, as company valuations decrease in bad times, borrowing money becomes more expensive. At the same time, there is also a consistently negative relationship between risk-free sovereign yields and credit spreads.
When the two interactions conflict—for example, when stock and bond prices rise simultaneously during a curve inversion—our analysis indicates that the interest rate effect prevails: corporate bond risk premia will widen as soon as long sovereign yields start to decline, which is what we observed in the last quarter of 2018. As the 10-year US Treasury yield descended over 60 basis points from its peak in early October, the average spread on sub-investment grade securities surged by more than 100 basis points.
G4 10-year government bond yields (left) and sub-investment grade bond spreads (right)
4. Higher interest rates making a currency more attractive
The value of a currency should increase when interest rates rise, as the higher expected return attracts foreign investors. When inflation fears haunted the US markets in February and April 2018, for example, the dollar appreciated on the prospect of a more aggressive response from the Federal Reserve Bank—despite severe stock market losses. The pound also climbed whenever hopes arose that the BoE might raise rates, irrespective of the ongoing Brexit uncertainty.
Evidence from previous BoE hiking cycles also supports this positive relationship between the pound and the Bank’s base rate.
5. Central bank policy divergence as political risk in Europe persists
The monetary policies of the big central banks used to be fairly aligned across regions but the current interest rate differential between the Fed and its European counterparts is likely to persist. Ongoing political uncertainty around Brexit, rising populism, and the wide variety of economic and fiscal conditions within the single-currency bloc compel European central bankers to adopt a much more careful approach to raising rates than their North American colleagues. The BoE has so far only hiked rates twice—compared with eight moves from the Fed—and the ECB is not expected to raise its refinancing rate before autumn this year, although the latter did end its asset purchasing program from the start of 2019.
Axioma’s Global Multi-Asset Class Portfolio
This analysis is based on Axioma’s global multi-asset class model portfolio, which is comprised of developed and emerging market stocks, sovereign bonds, inflation-linked securities, investment-grade and high-yield corporate debt, as well as cash holdings in the G4 currencies (USD, EUR, JPY and GBP) and commodities (gold and oil). We track the change in risk of the overall portfolio, as well as its breakdown by asset class and factor types, in our weekly Multi-Asset Class Risk Monitor newsletter, to which you can subscribe here.
