Market volatility reigns amid Russia-Ukraine conflict

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook: Nuveen's 2022 Outlook: 

• U.S. economy: Slower growth and inflation compared to 2021, but still pretty fast.
• Global economy: Showing signs of heating up thanks to accelerating vaccination rates.
• Policy watch: No more stimulus, but the Fed isn’t likely to raise rates too quickly.
• Fixed income: Expect further challenges for rate-sensitive assets; consider assuming more credit risk.
• Equities: Our cyclical tilt includes U.S. small caps and non-U.S. developed market shares.
• Asset allocation: Although valuations appear relatively full across many segments, we’re leaning toward risk-on positioning.

Quote of the week:

“How terrible a time is the beginning of March. In a month there will be daffodils and the sudden blossoming of orchards, but you wouldn’t know it now. You have to take spring on blind faith.” — Beatriz Williams

What the shape of the U.S. yield curve may be telling us

One result of last week’s market turmoil was a further flattening of the yield curve, a trend that — until the Ukraine crisis swept it from the headlines — had become a source of concern for many investors. But what exactly does it mean for the yield curve to flatten, or possibly invert? And why should investors care? 

By way of introduction, the yield curve is a graph showing how much a given part of the bond market, such as U.S. Treasury securities, is paying holders of those bonds across a spectrum of short-, intermediate- and long term maturities. The simplest definition of yield, which is expressed in percent terms, is the amount of interest paid by the bond, divided by its price. 

Investors tend to focus on the U.S. Treasury curve, because yields on some maturities are used as benchmarks for other interest rates (e.g., home mortgages) and because the relationship between yields on different points of the curve can convey certain market expectations about the economy.

Of particular interest is the yield differential between the 2-year Treasury note (which is highly sensitive to potential changes in Federal Reserve monetary policy) and the 10-year note (which reflects the market’s outlook for long-term growth and inflation). 

Most of the time, this “2/10” curve slopes upward, meaning the 10-year yield is higher than the 2-year. That’s because investors demand greater compensation for tying up their money for a longer period of time. But sometimes the 2-year yield rises by more than the 10-year yield does. When this relative shift occurs, the yield curve flattens, as it has so far this year. 

Specifically, on the last trading day of 2021, the 10-year yield closed at 1.52%, versus 0.73% for the 2-year yield — a spread of 0.78%, or 78 basis points.⁵ By last Friday’s market close, the 10-year yield had climbed to 1.97%, up 45 basis points year to date, but the 2-year yield had jumped even more, by 82 basis points, to 1.55%.⁶ This resulted in a much narrower yield difference of 42 basis points between the two maturities, and thus a flatter curve. Such flattening is typically viewed as a bearish economic sign, indicating a pessimistic market view of the economy’s long-term outlook. 

If the absolute level of a longer-term yield falls below that of a shorter-term yield, the curve between those two maturities has not only flattened but inverted — signaling potentially greater economic risk. Indeed, yield curve inversions have preceded every U.S. recession over the past 50 years. 

The last time the yield curve inverted was in 2019, when 3-month Treasury bills paid a higher yield than the 10-year Treasury note for about 4½ months beginning in late May of that year.⁷ Headlines warned of an impending economic downturn, and sure enough, a recession ensued in the first two quarters of 2020. This wasn’t proof that the yield curve acts as a “crystal ball,” however, as that recession was fueled by an unforeseen global pandemic. 

What about today’s flattening curve? Is it a roadmap for a sharp slowdown, or worse, an imminent recession? We don’t think so. By most measures the current U.S. expansion is still alive and well. The 10-year Treasury yield has been driven up by stronger growth and hotter inflation forecasts, while the spike in the Fed-sensitive 2-year yield reflects market expectations for higher inflation in the near term and as many as seven rate hikes in 2022. The net takeaway: growth, inflation and interest rates will remain elevated for some time before moderating as some heat is taken out of the economy. 

We see mixed implications for investors from the flatter yield curve. Most directly, holders of short-term fixed income or cash should see their returns start to rise after years of being close to zero. On the equity side, a flatter yield curve can be challenging for banks, whose operating model relies on borrowing money for short periods at low rates and lending it out for longer periods at higher rates. More generally, however, rising rates and a flatter curve are entirely consistent with solid to strong performance from stocks. Higher mortgage rates can be challenging for the real estate market, especially in light of the recent sharp increase in home prices, but borrowing costs remain low in historical terms, and households have an uncommonly large amount of cash on hand. 

We caution against over-interpreting changes in the shape of the yield curve or giving too much credence to financial news headlines that focus on recession predictions. Interest rates are rising across all maturities from very low levels for reasons that are generally benign. The start of 2022 has been bumpy for markets, but we see better times ahead for diversified investors.