There are few indicators that attract as much attention in the asset management world as the yield curve. The yield curve is a visual representation of the annualized yields of bonds of equal credit quality but differing maturity dates. The U.S. Treasury yield curve is referenced most often, but there are curves for other segments of the fixed income market such as those for investment grade corporate bonds, high-yield bonds, and municipal bonds. The yield curve is scrutinized as it is a reliable indicator of market sentiment and offers glimpses into investors' expectations for economic growth, inflation, and future Federal Reserve policy. Similarly, Central banks and policymakers monitor its movements to gauge the appropriate stance of monetary policy. For asset managers, the curve plays a crucial role in shaping investment strategies.
What is the Curve Telling Us?
The screenshot below plots the yield curve for U.S. Treasuries as of July 31, 2023. It also shows what the yield curve used to look like at the end of 2021 and 2022.
Source: JP Morgan
One of the most striking features of this chart is the extent to which yields have risen since the end of 2021. Across the entirety of the curve, yields have shifted higher. This is true not just of Treasuries but also in other segments of the fixed income market. The implication is that fixed income as an asset class has become a much greater investment opportunity than it has been in a long time.
Another important takeaway from yield curve concerns its shape. It is currently “inverted,” meaning that a lower annualized yield is on offer for long-term bonds than for short-term bonds. The curve can change shape over time because yields do not move in lockstep. Since 2021, shorter maturity bonds have experienced a greater shift higher than longer maturity bonds. The yield on a 1-month T-Bill for example, has risen by ~ 5.5% while the yield on a 10-year government bond has risen by ~ 2.5%. This remarkable shift higher at the “short end” of the curve is due to the Federal Reserve raising the Fed Funds rate (the overnight rate) to combat inflation. The Fed’s decisions have a direct impact on short-term rates while longer term rates are determined by the bond market.
Considering the inverted shape of the curve and the high yields on offer, T-Bills have clearly become an attractive investment opportunity. Indeed, we strongly encourage our clients to invest any cash set aside for near-term liquidity needs into short-term T-Bills. However, in portfolios with medium- to long-term time horizons, we advise extending maturities further into the future. It may seem counterintuitive, but it can make sense to buy a bond with a lower yield and longer time to maturity than a higher yielding one with a shorter maturity. This is because, by extending maturities, investors can have greater control over their cash flows in the future, rather than being subject to reinvestment risk - the risk of having to reinvest a maturing security at a lower interest rate in the future.
Lock-in yields before it’s too late
We anticipate that interest rates across the curve will fall in response to slower economic growth. The Fed appears to be winning the battle against inflation, but in so doing, the economy is taking a hit. Leading economic indicators such as the ISM Manufacturing Index and the Purchasing Managers’ Index (PMI) are very weak. As such, we believe that the Fed is nearing the end of its interest rate hiking cycle, and the Fed Funds rate will soon peak. In fact, the futures market now expects that the Fed will begin cutting interest rates at the beginning of 2024. When the Fed cuts rates it means that those who have been investing in very short-term bonds will face the prospect of reinvesting at lower and lower yields – yields that could even be lower than current long-term rates. Therefore, locking in yields further out along the curve today becomes critical.
Moreover, as we saw in 2022, yields along the curve don’t move in lockstep. Even before the Fed begins cutting rates, we expect the bond market will begin pricing in a lower Fed funds rate in the future. In other words, yields further out on the curve will drop. At that point, the chance to lock-in today’s high yields will have evaporated. The chart below shows how, in the past three rate hiking cycles, yields further out on the curve dropped significantly after the Fed Funds rate peaked. This is especially true of bonds with 3-to-5-year maturities.
Source: Charles Schwab. The dates for the peak rate and six months after for each of the three rate-hike cycles are: 12/19/2018 and 6/19/2019, 6/28/2006 and 12/26/2006, and 5/16/2000 and 11/16/2000.
We anticipate an imminent peak in the Fed Funds rate, and a shift downwards in the yield curve. This means that investors may soon miss the chance to lock in the attractive yields on bonds with a longer time to maturity. Within our separately managed accounts we are using a bond laddering strategy in which we hold multiple target-term bond funds to maturity. Our target-term bond funds extend out to 2028. By holding to maturity, we are locking-in the most attractive points on the yield curve. It gives our clients predictable cash flows and mitigates re-investment risk.
As rates begin to fall, reinvestment opportunities will evaporate across the curve. We advise locking in yields before it's too late.
Disclosures: This information was produced by, and the opinions expressed are those of Accuvest as of the date of writing and are subject to change. Any research is based on Accuvest’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however, Accuvest does not make any representation of their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Accuvest, and do not represent all of the securities purchased, sold, or recommended for client accounts.
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