Recent changes in US Yield Curve and forward inflationary expectations
Capital in its essence is underpinned by its cost. Without knowing the cost of capital, no investment can be fairly valued which will lead to market inefficiency.
The culminating determinant for global investments is the US yield curve, as it acts as the benchmark cost of capital at various maturities; from overnight rates to 30+ year rates.
This means that the shape of these aforementioned maturity rates have a direct impact on global markets.
Put simply, the typical yield curve tends to be upward sloping as lenders will demand higher rates the longer the maturity, given the positive relationship between uncertainty and maturity.
Finance defines this relationship as the maturity risk premium.
Last week, the US yield curve steepened as markets priced-in favourable economic metrics as global risks marginally receded given the easing in trade tensions between the US and China.
The Federal Reserve expects core Purchase Consumer Expenditure (PCE) to end the year at 1.6%, whilst it expects 2020 to stand at 1.9%.
The widely followed, 5 Year 5 Year forward inflation expectations index provide clues on price-based inflationary expectations by market participants.
The year to date trend shows a decline as global risks increased. However, over the last quarter there was a reversal in trend.
Over the 3 month period, the index averaged 1.70%, whilst the most recent reading stands at 1.84%.
Investors keep a close eye on these types of indices as they reflect market expectations in a timely manner which will have a direct impact on the overall interest rate risk management of an investment portfolio.
As noted earlier, the typical yield curve is upward sloping, however, that’s not always the case.
Specifically, when markets determine that a slowdown is to be expected, the yield curve gets flatter or even inverts.
This occurs when credit markets perceive the slowdown to result in lower inflationary pressures which will result in longer dated paper becoming less sensitive to overall interest rate risk.
Comparatively, the US has higher interest rates around the world backed by stronger economic momentum relative to global peers which is reflected in its monetary cycle.
Looking at the UK for instance, Brexit uncertainty has weighed heavily on the economy which led the country’s yield curve to remain relatively flat.
Likewise, Germany experienced a slump in manufacturing activity resulting in lower economic momentum with its yield curve remaining relatively flat.
In the US’s case, the difference in yield between the 10 Year and 2 Year Treasury Bond is closely followed by markets to determine the steepness of the yield curve. A steeper yield curve reflects inflationary expectations which has a direct implication on forward economic expectations.
The latter part of 2019 saw the difference between the two maturity points breach zero into negative territory.
This meant that the yield curve inverted marginally between the two maturity buckets. This was the lowest point in 5 years on the back of global uncertainty (mainly driven by US-China Trade Tensions).
However, as tensions eased, the steepness recovered which now stands at circa 30 basis points. In conclusion, investors need to keep in mind that despite the signals that yield curves may provide, the unprecedented monetary accommodation observed by the ECB and Fed over recent years diluted its effectiveness.
The level of liquidity injected in markets will have a profound impact on asset prices which ultimately determine the shape of the yield curve.
This article was issued by Jesmar Halliday, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.