The Significance of a Flattening Yield Curve and How to Trade It

 | Nov 24, 2017 | 7:00 AM EST
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In the last few weeks, the financial media seem to have gotten wind about the flattening of the yield curve. I've been recommending curve-flattener trades for a while, so hopefully this hasn't caught Real Money readers by surprise. However, with the increased attention to the flattening, it is begging more questions. Why does the curve flatten? Does a flat curve predict a recession? Here are my thoughts.

The slope of the yield curve is correlated with recessions...

A flat yield curve simply means that the yield difference between short-term bonds and long-term bonds becomes small, or even negative. For example, at the beginning of the year the two-year Treasury yielded 1.19% and the 10-year yielded 2.44% for a difference of 125 basis points. Today those same two maturities yield 1.77% and 2.36%, respectively, for a difference of just 59 basis points. We call it "flattening" because a plot of yields by maturity (called the "yield curve") literally looks flatter. The chart below shows what has happened year to date, and the red lines show the specific slope from two to 10 years.

Source: Bloomberg

If you look at that 2-10 year slope over time, you indeed see that the slope tends to go negative (also called inverting) just before the economy goes into recession. The chart below has recession periods shaded.

Source: Federal Reserve Bank of St. Louis

... but the inverted curve is a symptom, not the disease

Too often the flattening of the yield curve is described as though it occurs in a vacuum. Truth is that the yield curve flattens when the Fed is hiking rates. The reasons are pretty simple. The Fed directly sets overnight rates. While that overnight rate influences all other rates, it logically has a greater influence on shorter rates than longer rates. Hence, shorter-term yields go up faster than longer-term yields as the Fed is hiking. You can see this very clearly if we compare the 2-10 year slope from the chart above with the overnight fed funds rate.

Source: Federal Reserve Bank of St. Louis

Here I've added fed funds in green and circled spots where a Fed rate-hiking cycle reached a local peak. You can see that each of those peaks coincide with a point where the yield curve also reached a local low. In other words, if history repeats, you just about can guarantee that if the Fed keeps hiking, the yield curve will keep flattening. This puts the idea that an inverted yield curve presages a recession in a new light. The thing we really see is that the Fed gets to a peak and the yield curve inverts.

Recessions stem from tight monetary policy

It is when money gets too tight that we get recessions; the flattening yield curve is just a by-product of money getting tight. There isn't any special indicator that it has gotten "too tight." In 1995 and 1998 the curve got extremely flat, briefly inverting in 1998, but neither instance turned into a recession. There also have been inversions that happened well before a recession hit, such as 1989 and 2006. In both cases it was nearly two years before we were actually in a recession.

The correct way to think about the curve slope is that the curve generally should flatten as the Fed hikes. Short-term rates will keep rising along with Fed hikes at a close to 1-to-1 ratio. Longer-term rates may rise, too, but they will slow down or even fall as the market anticipates the Fed is nearing an end to its hiking cycle. That might mean a recession is coming, but might just mean the Fed won't be hiking that much more.

Doing the twist

The thing you are seeing today from the bond market fits with this thought perfectly. If you look back at the first chart showing the yield curve today versus the start of the year, we see that 10-year rates are about unchanged and 30-year rates are slightly lower, something bond guys call a "twist." Per my statement above, this is the market saying that the Fed is near an end to its rate hiking cycle. Indeed, if you look at fed funds futures, the market seems to be pricing a little more than two more rate hikes for this cycle. As we get even closer to the peak of this cycle, shorter- and shorter-term rates will stop rising.

How should you trade this?

My core trade on the yield curve is to be short, or underweight, the 3-7 year part of the yield curve and overweight 10-30, shaded toward 20-30. In ETFs, this trade can be accomplished by being short an ETF such as iShares 3-7 Year Treasury Bond Fund (IEI) and long iShares 20+ Year Treasury Bond (TLT) at a 3-to-1 ratio.

I don't mind being short the 3-7 year part of the curve outright, but that trade depends greatly on how much more the Fed hikes. I believe the market is underestimating Fed hikes in 2018 in a steady state, plus I also think there is much more room for the Fed to hike more than less. My basic feeling is that the Fed will keep hiking at a pace of three to four times a year until the economy slows. Right now the market is basically pricing that the Fed will be done by the time 2019 rolls around. If that turns out to not be true, the 5-year Treasury will be meaningfully higher than 2.10% and the curve will be meaningfully flatter.

I personally think just betting on the curve flattening is an easier trade. All I need for the curve to keep flattening is for the Fed to keep hiking, whereas for an outright short to work the Fed needs to hike high enough and fast enough. Remember that when you are short bonds, you have to pay out the yield. So even if rates rise, if they don't rise more than the yield you had to pay out you don't make any money. So I generally don't like being outright short unless I have identified a near-term catalyst.

A better way to play an outright view that the Fed will get tighter is to go long the dollar. With that trade you can have more time to be right and have more outs even if the Fed isn't as hawkish as I think.

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