A Flat Yield Curve is Not All Bad Investment Grade Market Outlook
2017 was a year characterized by low volatility, a flattening yield curve and narrowing corporate bond spreads. The economy grew modestly and the Federal Reserve (the Fed) began to pull back its monetary accommodation. What has been missing so far is a rise in inflation. For 2018, we believe the biggest challenge in the investment grade space will be finding opportunity while effectively managing interest rate exposure.
In 2017 the yield curve flattened sharply, especially in the second half of the year, while investment grade corporate spreads narrowed and volatility declined. The 10-year Treasury yield traded in a 60 basis point (bp) range for the entire year and ended the year a mere 4 bps lower than a year ago, while the 2-year Treasury yield increased by 70 bps. 2017 also marked the first time in this cycle that investors believed the Fed’s forward guidance on rates — also known as “the dot plot” — and short-term interest rates experienced an accelerated upward trajectory (see Figure 1 below). We expect the latter to continue in 2018 as the synchronous global economic recovery continues and the quantitative easing programs that characterized the earlier part of this decade are slowed, halted and, in some cases (including the U.S.), reversed.
Investors typically look at the yield curve as an indicator of where we are in the interest rate and economic cycle. The last time we embarked on a tightening cycle (2004-2006), the yield curve inverted after about 75% of the rate hikes were completed. Looking ahead we believe that in 2018 we may see 3-4 rate hikes, bringing the fed funds target to 2.25-2.50%. This is around 75% of the way to our expected terminal fed funds target rate of just north of 3.00%. Given that, it stands to reason that the Treasury curve could easily be flat (as measured by the difference between 10-year yields and 2-year yields) by year’s end. Historically, flat yield curves have been predictors of recessions, but we do not believe that to be the case in this circumstance, as the absolute level of yields remains very low. A flat yield curve at 3% remains very accommodative from a historical perspective – and with corporate and mortgage spreads at multi-year lows, funding costs should remain relatively low compared to periods where the curve has flattened/inverted in the past.