Don’t Worry Too Much About Flatter Yield Curve

This date will be seen on the market commentaries main page May 09, 2018

By Dale Hoffman, USAA Portfolio Manager


The current Treasury yield curve is much flatter than it was a year ago, or even three months ago. How concerned about this should we be? In our view, investors may want to be watchful, though perhaps not overly worried.


A flattening yield curve is viewed as problematic, mostly because it can lead to an inverted yield curve. In this unusual and undesirable scenario, Treasuries with shorter maturities have higher yields than bonds with longer maturities. The underlying concern is that a recession could be coming. Since the end of World War II, every recession has been preceded by a yield curve inversion (though not every inversion has resulted in recession).


As of Monday, the five-year Treasury note carried a yield of 2.78 percent and the 30-year Treasury bond’s yield stood at 3.12 percent - a spread of 0.34 percent, or 34 basis points (BP’s). Back on Feb. 7, the spread between the same two bonds was 65 BP’s, and a year ago, it was 113 BP’s. This trend represents a significant flattening over a short period of time.



The Federal Reserve has been a big contributor to the tightening spreads. Since last May, the Fed has raised short-term interest rates three times, and another 25 BP’s increase is almost certain to come next month. After that, expect at least one more hike before the end of the year. We are yield-focused bond investors, so we welcome higher interest rates because over time the compounding of coupon payments accounts for the lion’s share of a bond’s total return.


Action by the Fed exerts considerable influence on the yields of shorter-maturity bonds, but not necessarily at the longer end of the curve. Since the Fed began its slow monetary tightening cycle in mid-December 2015, the yield on the one-year Treasury has risen more than 150 BP’s, while the 30-year’s yield has gone up only 12 BP’s.


Why has the 30-year yield barely budged over the last 30 months? It mostly comes down to demand for the security. Longer-maturity bonds often serve as a safe havens when investors fear geopolitical issues, slowing economic growth or stock-market volatility. Like any other product in limited supply, demand for a bond tends to drive up its price. And as a bond’s price rises, its yield drops (and vice versa).


A similar dynamic is playing out in the municipal (muni) bond market, although the muni yield curve is not as flat as that of Treasury’s. After a late 2017 spike in issuance to beat the Federal tax cut, new supply has been scarce. At the same time, demand for munis has been relentless from both domestic and overseas buyers seeking low-risk, incremental yield.


While the Treasury yield curve has flattened in recent months, we think there’s only a slim risk of an inverted curve in 2018.


In our view, the shorter end of the curve has already priced in much of the impact of this year’s expected Fed rate hikes. Going forward, that could mean less upward pressure on yields at that end.


While the demand for safe haven assets is hard to predict, the U.S. economy appears to be on solid footing, with inflation fairly well contained even with the headline unemployment rate under 4 percent. In addition, surprisingly strong earnings growth in the first quarter (and optimistic forecasts for the rest of the year) brings down equity valuations to levels closer to the long-term average.


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This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.


Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.


Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met.


Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S.  Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.


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