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Which Curve?

London roads

Executive Summary:

Understanding bond yields and yield curves is an essential part of view formation. As we navigate the new regime, probable policy error, and the upcoming slow down, it is essential that we pay attention to the relevant yield curves. Swap rate curves offer superior information value compared to treasury yield curves and are often used to gauge the point in economic cycle we are in.

Monetary policy changes often affect the near-term policy rates. Longer term yields are usually a function of structural inputs such as GDP, longer term inflation trajectory, technology, etc.

This article’s emphasis is on the type of yield curves, tenor, and what information value we draw from it for the upcoming changes in the yield landscape.

A thorough understanding of fixed income markets is an essential component of a forward-looking asset allocation process. In this short piece we will address yield composition, risk-free rates, yield curve inversion and how these factors drive investment view formation.

US treasury yields with duration between 2-years and 10-years (known as 2/10 treasury yields) are often discussed in the financial press – and for good reason. In many ways this segment of government bonds is used to determine the economic pulse or well being and has been used many times to assess the likelihood of recessions. Of course, key changes in this economic barometer are a function of sentiment, expectation, and supply/demand like all asset classes. Where professional investors perceive the near-term future to look bleak, they will of course move investments away from the impact zone into other areas less impacted or with a brighter outlook. So, 2/10 yields offer a view of investor sentiment and important behavioural activity, they do not provide information about borrowing conditions for the real economic agents. For this information we need to drill into yield composition and risk-free rate.

Bond yields can be broken down: risk-free rate + asset swap spread + credit spread.

For a US treasury the key elements to review are risk free rate and asset swap spread. The closest proxy for the risk-free rate is the return available on overnight cash parked on deposit in local currency at the central bank – offering zero credit risk. Obviously, this return cannot be compared to a 10-year treasury bond. However, an overnight index swap curve is available to us, and this offers clear insight to implied overnight deposits at the central bank over different time periods. So, in simple terms – a deposit over the next 10-years at a central bank at a Federal Fund’s Rate (implied by the index swap curve), is the risk-free rate and would differ from the 10-year treasury bond yield.

US Treasury 2022

Source: Bloomberg

As at 24 May 2022

Over the years we have noticed an anomaly when comparing the index swap curve and the treasury yield curve. We noticed the long end of the yield curve sat below swap rate curve and wondered why this would be the case? Whilst it served as a good signal for the direction of travel for yields – the technical aspect of this phenomenon was intriguing. As demonstrated above in the chart, the index swap rate curve is an implied overnight deposit rate curve and carries no Asset Swap Spread, hence it can sit under the treasury yield curve. Asset swap spread becomes significant over longer duration – hence the difference, as we move beyond the 2-year duration.

With yield curve inversions we know this represents the supply and demand dynamics of the market but with the index swap rate curve we know this represents the real borrowing costs for corporates and other economic agents. The inverted curve shape therefore explains that borrowing costs are becoming more expensive over the near term compared to lower rates over the longer term. The index swap curve represents expectations for Federal reserve rates over time.

Let’s return to curve inversions. Curve inversions are relevant, whilst the treasury curve inversion can be chalked down to demand and supply dynamics of the bond market, the index swap curve inversion can be read as borrowing conditions for real economic agents are getting tighter in the near term compared to lower rates at the longer end. The index swap curve reflects the term structure of market participant’s expectations for Federal Fund rates over time:

SOFR swap Rate

*(SOFR is a proxy and is based on Treasury repo transactions)

So, the question then is which curve inversion to look at? 30/5 index swap curve and 10/2 swap curve? We consider the 2- and 5-year short end of the curve to be most appropriate as this is the average length of the recent hiking cycles (1986/89, 1994/00, 2004/07, 2015/19). 10 and 30 years are considered long enough for structural factors to have an impact on potential growth and regime change in long term inflation trajectory. Structural factors such as demographics, technical advances, long term GDP growth and long-term inflation trajectory.

30Y Treasury Yield Bloomberg

(30Y Treasury Yield)

Source: Bloomberg

As at 24 May 2022

The 30-year treasury yield very rarely departs from its secular downtrend. It has had regime changes during the period covered – QE, hyperinflation, taper tantrums, bond market blow-ups, the most recent one being inflation’s unwelcome return. The question now is whether the recent bout of exogenous inflation and tighter monetary policy will result in a long de-leveraging episode or a recession - and will reset us back into a growth path?

The extent of central bank policy error remains to be seen. The bond market is already flashing with a risk of possible stagflation and an economic “hard landing”. The 30/5-year index swap curve has been inverted for more than a month, pricing in tighter conditions for economic agents in the near term. The 30-year yield is showing signs of regime change but as far as it does not deviate from its secular trend, the expectation is it should revert to the Federal Funds terminal rate of around 3%.

It is interesting to mention here a comment made by Federal Reserve Chairman Jerome Powell during the latest press conference: “It may require considerably more hikes than the market has experienced in recent years before the Fed can get ahead of this bout of supply-shock-driven inflation”. Chair Powell also acknowledged that monetary policy tools have limited use against such exogenous shocks with roots in a geopolitical crisis.

This would point to monetary policy tools being used to curb the demand side of the economic equation and in the process destroying the public’s spending power whilst the supply side inflation remains out of control. In such a scenario – bond markets may signal “brace for impact”!

What does this mean for interest rate risk in our portfolios? We are in the process of moving some of our shorter-end exposure to zero duration cash and some into the longer end of the curve, ahead of the yield squeeze.


Important Information

This material is directed only at persons in the UK and is not an offer or invitation to buy or sell securities.

Opinions expressed, whether in general, on the performance of individual securities or in a wider context, represent the views of Alpha Beta Partners at the time of preparation. They are subject to change and should not be interpreted as investment advice.

You should remember that the value of investments and the income derived therefrom may fall as well as rise and you may not get back your original investment. Past performance is not a guide to future returns.

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