Seeking Alpha

A Different Read Of The U.S. Yield Curve

by: Richard Turnill

Key points

  • The U.S. yield curve's recent steepening offers a reminder that global factors - such as Bank of Japan monetary policy - help shape the curve.

  • Global stocks finished last week flat amid escalating trade conflicts. The U.S. 10-year yield crossed 3% before retreating.

  • U.S. inflation reports out this week are likely to keep the Federal Reserve on a path of raising rates two more times this year.

The U.S. yield curve's recent steepening - after a period of persistent flattening - reminds us that the spread between two- and 10-year Treasury yields reflects much more than the state of the U.S. economy. Global interest rates and monetary policy also play a role in shaping the curve, with a recent tweak in Bank of Japan (BoJ) policy helping drive the mild steepening.

Government bond yield curves, 2016-2018

The BoJ announced it would allow 10-year bonds to move in a wider range. Why would this affect the U.S. yield curve? Global investors often seek out the highest long-term yields. The U.S. was the most attractive destination among developed markets for some time, given its greater progress toward economic recovery and rate normalization. This spurred inflows to U.S. debt markets that helped contain the rise in long-term Treasury yields, as Fed rate increases pushed up the short end.

The result: a closing gap between 10- and two-year yields, as the orange line in the chart shows. The German curve, by contrast, remained relatively steep (green line). Now, as evident in the far right of the chart, we are seeing the U.S. yield curve steepen a bit amid speculation that rising yields in Japan could lure Japanese investors back home and prompt them to sell some of their holdings in long-term U.S. debt.

Strong growth, but rising uncertainty

Rising long-term Treasury yields should help alleviate market concern of a U.S. yield curve inversion - a signal that often prompts fears of a recession. The curve's persistent flattening has been led by increases in short-term interest rates amid rising market confidence that the Fed will carry on with policy normalization. Markets are now pricing a high probability of the Fed raising rates another quarter percentage point at its September meeting, and we see one additional 2018 increase likely to follow.

This confidence has been fueled by strong U.S. economic momentum. Our BlackRock Growth GPS signals U.S. growth well above trend over the coming year and indicates consensus expectations of U.S. growth prospects may still be too cautious. Insatiable global appetite for both yield and perceived "safe" assets, along with high global savings, will continue to help hold down the long end of the U.S. curve, in our view.

We see strong U.S. growth spilling over into the global economy. Our GPS points to steady and sustained global growth over the coming 12 months - even as economic uncertainties rise due to U.S. overheating risks and escalation of trade conflicts. Major central banks outside the U.S. are preparing to move toward normalization, albeit much more slowly than the Fed.

We see global investors seeking out higher currency-hedged yields in these regions, potentially reducing their demand for U.S. Treasuries. Supply factors are driving up longer-term U.S. rates, too. A recent U.S. Treasury Department advisory report suggested shifting more issuance toward longer maturities as the Treasury seeks to fund the U.S. fiscal deficit.

The bottom line: The U.S. yield curve provides less information about recession risk than it has historically and is shaped by many factors. We see solid growth ahead, but rising macro uncertainty underscores the role of fixed income as ballast in portfolios. We prefer short-duration debt in this rising rate environment and favor an up-in-quality stance in credit as an offset to equity exposure.

Week in review

  • The BoJ expanded the range it allows for 10-year government bond yields and made other minor policy tweaks. The Fed kept interest rates on hold and expressed confidence in the U.S. economic outlook. The Bank of England raised rates for the second time since 2007. U.S. 10-year Treasury yields crossed 3% for the first time since mid-June before retreating, while Japanese 10-year yields touched the highest level since 2016.
  • Stocks traded flat. Earnings were strong, but trade conflicts escalated. U.S. President Donald Trump told his trade official to consider a 25% tariff on $200 billion of Chinese goods, up from 10%. China proposed a retaliation.
  • July U.S. job growth was solid but slightly lower than expected. The U.S. Employment Cost Index rose at its highest rate since 2008. PMIs for Asia and Europe pointed to moderate slowdowns in economic activity in those regions.

Week ahead

Date: Event
Aug. 6 Germany factory orders; Eurozone Sentix Investor Confidence Index
Aug. 7 Germany trade balance; China foreign exchange reserves
Aug. 8 China trade balance
Aug. 9 U.S.-Japan trade talks; China Consumer Price Index (CPI), Producer Price Index (PPI); U.S. PPI
Aug. 10 U.S. CPI; Japan Q2 Gross Domestic Product (GDP); UK Q2 GDP, industrial production; International Energy Agency’s Oil Market Report

U.S. inflation data this week should keep the Fed on a path of two more rate increases this year. U.S. core inflation has been rising since November 2017, and economists see the trend persisting. They expect both headline and core consumer inflation to increase from the previous month. This is in line with our BlackRock Inflation GPS, which suggests U.S. core inflation should remain slightly above the Fed’s target in the near term. The 2.7% annual rise in average hourly earnings in the July U.S. jobs report also lined up with this inflation picture. Elsewhere, China’s PPI could hold steady after last month’s strong print, underpinning our view of stabilizing Chinese growth.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps 0.8% 6.2% 14.9% 1.9%
U.S. Small Caps 0.6% 9.7% 20.6% 1.2%
Non-U.S. World -1.4% -2.6% 4.1% 3.2%
Non-U.S. Developed -1.4% -1.5% 4.1% 3.4%
Japan -1.8% -1.4% 7.6% 2.3%
Emerging -1.7% -5.8% 3.2% 2.9%
Asia ex-Japan -2.4% -5.8% 3.4% 2.7%

Bonds Week YTD 12 Months Yield
U.S. Treasuries 0.1% -1.4% -1.6% 2.9%
U.S. TIPS 0.1% -0.5% 0.9% 3.0%
U.S. Investment Grade 0.2% -2.3% -1.1% 4.0%
U.S. High Yield 0.3% 1.4% 2.7% 6.3%
U.S. Municipals -0.1% -0.1% 0.7% 2.7%
Non-U.S. Developed -0.6% -2.2% -1.6% 1.0%
Emerging Market $ Bonds -0.5% -3.1% -0.8% 6.3%

Commodities Week YTD 12 Months Level
Brent Crude Oil -1.5% 9.5% 40.8% $73.21
Gold -0.8% -6.7% -4.2% $1,215
Copper -1.4% -14.4% -2.3% $6,206

Currencies Week YTD 12 Months Level
Euro/USD -0.8% -3.6% -2.5% 1.16
USD/Yen 0.2% -1.3% 1.1% 111.25
Pound/USD -0.8% -3.8% -1.0% 1.30

Source: Bloomberg. As of August 3, 2018
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Asset Class View Comments
Equities U.S. icon-up Unmatched earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view. We like momentum. We prefer quality over value amid steady global growth but rising uncertainty around the outlook. Financials and technology are our favored sectors.
Europe icon-down Relatively muted earnings growth, weak economic momentum and heightened political risks are challenges. A market dominated by value sectors also makes the region less attractive in the absence of a growth upswing.
Japan The market's value orientation is a challenge without a clear growth catalyst. Yen appreciation is another risk. Positives include shareholder-friendly corporate behavior, solid company earnings and support from Bank of Japan stock buying.
EM icon-up Economic reforms, improving corporate fundamentals and reasonable valuations support EM stocks. Above-trend expansion in the developed world is another positive. Risks such as a rising U.S. dollar, escalating trade conflicts and elections argue for selectivity. We see the greatest opportunities in EM Asia.
Asia ex Japan icon-up The economic backdrop is encouraging, with near-term resilience in China and solid corporate earnings. We like selected Southeast Asian markets but recognize a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.
Fixed Income U.S. government bonds icon-down We see rates rising moderately amid economic expansion and Fed normalization. Longer maturities are vulnerable to yield curve steepening but should offer portfolio ballast amid any growth scares. We favor shorter-duration and inflation-linked debt as buffers against rising rates and inflation. We prefer 15-year mortgages over their 30-year counterparts and versus short-term corporates.
U.S. municipals Solid retail investor demand and muted supply are supportive, but rising rates could weigh on absolute performance. We prefer a neutral duration stance and up-in-quality bias in the near term. We favor a barbell approach focused on two- and 20-year maturities.
U.S. credit Sustained growth supports credit, but high valuations limit upside. We favor investment grade (NYSEARCA:IG) credit as ballast to equity risk. Higher-quality floating rate debt and shorter maturities look well positioned for rising rates.
European sovereigns icon-down The ECB's negative interest rate policy has made yields unattractive and vulnerable to the improving growth outlook. We expect core eurozone yields to rise. We are cautious on peripherals given tight valuations, political risks in Italy and the upcoming end to the ECB's net asset purchases.
European credit icon-down Increased issuance and political risks have widened spreads and created some value. Negative rates have crimped yields - but rate differentials make currency-hedged positions attractive for U.S.-dollar investors. We are cautious on subordinated financial debt despite cheaper valuations.
EM debt Valuations of hard-currency debt have become more attractive relative to local-currency bonds and developed market corporates. Further valuation support comes from slowing supply and strong EM fundamentals. Trade conflicts and a tightening of global financial conditions are downside risks.
Asia fixed income Stable fundamentals, cheapening valuations and slowing issuance are supportive. China's representation in the region's bond universe is rising. Higher-quality growth and a focus on financial sector reform are long-term positives, but a sharp China growth slowdown would be a challenge.
Other Commodities and currencies * Declining global crude inventories underpin oil prices, with geopolitical tensions providing further support. We are neutral on the U.S. dollar. Rising global uncertainty and a widening U.S. yield differential with other economies provide support, but an elevated valuation may constrain further gains.

* Given the breadth of this category, we do not offer a consolidated view.

This post originally appeared on the BlackRock Blog.