The Yield Curve Provides Attractive Yields, Yet Ominous Predictions

Short-End Reacting to Monetary Policy Actions, Long-End Predicting these Actions Are Unsustainable 

In recent weeks, U.S. Treasury bonds have offered the highest yields since pre-Great Financial Crisis. As credit spreads have remained low – not indicating any spike in default risk from the macro environment – fixed income performance has been largely duration-driven. The Fed has implemented restrictive policy since March, and yields have risen in response to the Fed’s historic rate hike activity. As rates rise, prices fall, and the U.S. Aggregate Bond Index is down  -13.4% year-to-date. 

The front-end of the yield curve has reflected the Fed’s target overnight lending rate, and the 3-month Treasury Bill currently yields 4.3%. Longer maturity bonds have retreated lately, despite the recent Fed commentary indicating restrictive, “higher for longer” policy. The 10-year Treasury bond currently yields 3.6% – this is below the current Fed Funds target rate of 4.00%. The Fed Funds target rate is expected to rise another 50 bps upon the next FOMC meeting on December 14. 

An Opportunity for Real Yields 

Real yields (nominal yields minus expected inflation) are positive and, given the best yield opportunity in more than a decade, we’re advocating for investors to do something to capture the return opportunity. Investing in the front-end of the curve offers less duration risk and has outperformed the aggregate bond market in 2022. Investing in the long-end of the curve incurs greater duration risk, yet offers investors the opportunity to capture real yields for the next decade-plus. 

Chart 1: Today’s Yield Curve Much Higher, Inverted Compared to Recent Years¹ 

Investors can diversify their exposure across the curve as well, to capture high yields in the near term, while also locking in high yields in the long-term, which is why we see opportunity in barbelling maturities within portfolios. With a barbell, investors would overweight the short and long end of the curve. We believe this is advantageous because, if rates fall, investors benefit by opportunistically locking in higher-yielding long-term rates. If rates continue to rise, then as shorter-term bonds mature, investors can reinvest that principal back into the market at higher yields. Credit risk and sector risk can also be diversified by investing in different types of bonds. 

Inversion 

Yield curve inversion tends to predict recessions. 2yr/10yr inversion has inverted before every recession since the 1970s (there was one false positive in the mid-1960s). 3M/10yr is even more certain as a recessionary-indicator and is currently 80 bps inverted (its widest inversion since 1981). Inversion occurs because the bond market anticipates the Fed has reached a restrictive level, beyond what the economy can sustain long term, and thus the Fed will need to eventually cut rates in order to spur demand or support the labor market amid a recession. 

In a traditional, upward sloping yield curve, investors can purchase longer-dated bonds with higher yield and sell those bonds at lower yields as their maturity draws closer, called a carry trade. The duration risk in longer-dated bonds is embedded due to the extended maturity of those bonds. So if the Fed continues to hold rates higher for longer and the economy is able to sustain healthy growth in spite of the restrictive policy, those bond prices will fall as investors demand higher yields. 

Whether the Fed is able to maintain restrictive policy or needs to reverse course and begin to cut rates, inversion is not a positive indicator for continued policy or economic sustainability. 

Macro Data Is Driving the Bond Market and the Fed 

Next week, the November CPI report will be released. This will be the final CPI report of 2022. Leading up to next week’s CPI report, economic data has been mixed. Within the ISM manufacturing survey, new orders have contracted for the past 5/6 months – a leading indicator for revised lower earnings by about six months. Also, within the ISM manufacturing survey, prices paid fell for the eighth-straight month – a leading indicator for lower inflation by about six months. Housing, along with these leading indicators, has continued to slow and other headline inflation items like gas prices and rents have fallen from recent peaks. 

Positive economic data is incorporated in higher wages, low unemployment, strong retail sales figures and business activity in the services sector, which represents 80% of the U.S. economy. While earnings revisions have come down, companies may see lower costs in their supply chains and less FX headwinds as U.S. currency strength retreats with slowing Fed policy expectations. 

Good News Is Bad News, Bad News Is Good News 

It sounds counterintuitive, but it’s been a theme for the past six months. Markets have interpreted positive economic news as enforcing the Fed’s tightening policy. Bad economic news, like a slowdown in demand or less jobs, is interpreted as good news for the markets because it means the Fed policy is working and the Fed might stop (or slow their pace of) raising rates. 

We are seeing broad indication that inflation is retreating. There are exceptions, like wage pressure and uncertainty around commodities, but in aggregate, supply and demand dynamics are cooling inflation. 

The Fed has indicated a 50-bps rate hike at December’s FOMC meeting. The Fed is less focused on a fast pace of rate hikes, since it has expeditiously raised rates 375 bps this year, and is now focused on how long to sustain restrictive policy and determining an ultimate terminal Fed Funds target rate. 

The Fed has continued to emphasize that they need to see clear evidence that inflation is heading to 2% before they consider pivoting away from restrictive policy. Core PCE increased at an annualized +2.7% rate in October and remains +5.0% y/y. Next week’s November CPI report (released December 13) will be extremely important for markets interpreting the Fed’s forward policy – Fed Chair Powell speaks the following day. 

Chart 2: Elevated Inflation Through October Amid Record Pace of Rate Hikes and Low Unemployment² 

Sources

1. FactSet (chart). As of December 6, 2022.
2. FactSet (chart). As of December 6, 2022.

Disclosures 

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors. All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice. This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.