Upside Down…the Yield Curve Inverts

kevin-temp2
03/27/2019

Last week, the big news was that the U.S. Treasury (UST) 3-month/10-year yield curve became inverted for the first time since 2007. It is certainly a noteworthy development in bond-land. As of this writing, the closely watched UST 2-year/10-year spread is still on the positive side at 15 basis points.

 

Here are some quick insights:

  • The effect of last week’s Federal Reserve (Fed) meeting is still resonating, with any economic data being viewed through that prism accordingly.
  • The catalyst for this latest inversion may have been the continued soft performances of the eurozone Purchasing Managers' Indexes (PMIs), specifically those of the manufacturing sector and Germany.
  • The manufacturing PMIs for Germany, France and the eurozone are now all in recession territory, with Germany’s at its lowest level since 2012.
  • The 10-year German bund yield dropped into negative territory as a result of the PMIs.
  • This is important for the U.S. rate outlook because the Fed mentions global growth as one of its primary concerns.
  • U.S. economic data has been more mixed but does suggest a slowing in Q1 growth.
  • The U.S. PMI came in below consensus for March, but still safely above the “50” threshold of contraction versus expansion.
  • Existing home sales increased by 11.8% in February.
  • The data on housing, an interest-rate sensitive sector of the economy, is important because if the rise in U.S. rates is going to start having negative repercussions, this is a logical place for it to start.
  • At its meeting last week, the Fed lowered its 2019 gross domestic product (GDP) forecast by only 0.2 pp and kept core PCE unchanged. Three months ago, a somewhat similar scenario resulted in two rate hike projections, but now the result is none. Following the December FOMC meeting, the Fed may be operating with an overabundance of caution.
  • The most important outcome of last week’s Fed meeting may be that there was no mention of, or forecast for, rate cuts. In contrast, fed funds futures have now priced in one rate cut for this year.
  • The UST 10-year yield broke through the five-year Fibonacci 61.8% retracement of 2.5178. The next level is 50% retracement at 2.2887.
  • I’m not necessarily projecting this is where we go, but if upcoming U.S. economic data comes in soft, the glide path is there.
  • What about U.S. economy surprises to the upside? The UST market is not priced for this scenario at all. In fact, the UST 10-year relative strength index is back in “overbought” territory. It’s had a good track record.

 

Conclusion

 

How might an investor position their fixed income portfolio in the current environment? I think one should use the inverted yield curve to their advantage. With the WisdomTree Floating Rate Treasury Fund (USFR), investors can capture an average yield to maturity of 2.55%, as of this writing, with a duration of 0.02 years. Compare this to a UST 10-year note yield of 2.44%. The Treasury floating rate note strategy offers an innovative, strategic solution for the short-government allocation for fixed income.

 

Unless otherwise stated, all data is Bloomberg, 3/25/19.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal.  Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited.  Fixed income securities will normally decline in value as interest rates rise.  The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs.  Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
About the Contributor
kevin-temp2
Head of Fixed Income Strategy

As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.