Monthly Markets Memo - November 2017
by Dan Zalipski, CFA & Scott Rosenquist, CFA
Equities in the U.S. were largely unchanged in the past month with the S&P 500 up approximately 0.5%. The international developed markets took a breather with a 5 day sell-off, with most major international indices shedding approximately 1%. The slide seemed to be triggered by weakness in commodities, and lower expected demand for oil. Nearly every fixed income asset class posted negative returns over the past month. Solid U.S. economic reports helped push prices lower as investors shifted assets towards riskier spaces. The Fed signaled its intention to increase interest rates in December, and progress surrounding U.S. tax reform is also pushing yields higher, which in turn puts downward pressure on the fixed income prices.
The Yield Curve
The U.S. Treasury yield curve reveals the interest rates U.S. Treasuries are paying at various maturities. For many investors, the shape of the yield curve is more important and telling than the individual rates and data points. The long end of the curve is typically higher than the short end, as investors demand more yield to compensate for the longer time until maturity. In a typical economic environment, the yield curve is upward sloping. This indicates that longer-term maturities may see their yields increase in response to economic expansion. Once the economic expansion begins to slow, the yield curve may flatten. Central banks increase interest rates, pushing up the short-end of the curve, while the long-end declines in response to the decrease in expected future growth, resulting in the entire curve becoming relatively flat. In extreme cases, this combination of increasing rates and slowing growth can even cause the yield curve to invert, which is often accompanied by a recession.
Investors are taking note of the curve’s movement over the past year. The yield curve has been flattening, and as of this writing, is flatter than it has been in the past decade. The graph below reveals how the yield curve has flattened since the end of 2013, with the short-end rising, while the long-end is falling. The concern is that this movement is a warning of rough times ahead. In the past, a flattening yield curve was a reliable predictor of recession. Today, however, there may be other forces at work.
The most obvious force is the Federal Reserve. The Fed has picked up the pace of their rate increases in 2017 relative to the previous year. As interest rates are pushed higher, the short-end of the curve increases more than the long-end, contributing to the flattening of the yield curve. Another force is simple supply and demand. High demand can push yields lower, and the long-end of the curve is seeing plenty of demand from various sources, such as foreign investors. The low yields other nations are experiencing on their own government debt has investors looking at U.S. debt as more favorable. For example, the Germans might look at their own debt with their 10-year yielding ~0.50%, and decide that the U.S. equivalent yielding ~2.4% is a better buy. In addition to foreign investors, foreign central banks, amid their own quantitative easing programs, are generating additional demand on the long-end of the curve. Low inflation is also contributing to the downward pressure on the long-end of the curve.
In the past a flattening yield curve has been a warning sign, signaling slower growth and a possible recession. With the U.S. in the latter part of the current business cycle, there is a lot of effort put in to identifying that next inflection point that could lead to a recession. In the past, a flattening yield curve was a reliable predictor of an impending economic slow-down. However, in today’s environment, it would seem that external factors are disrupting the predictive power of the curve.
“An investment in knowledge pays the best interest." - Benjamin Franklin
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