Stranger Things

Published On: June 1, 2018

Written by: Ben Atwater and Matt Malick

If you’re a fan of the Netflix series Stranger Things, you know all about the “Upside Down World.”  If you’re not, we’d recommend checking it out.  As you might infer from the title, there is sci-fi, light horror and significant suspense in the show.  And, if you were a kid or a parent with younger kids in the 80’s, quite a bit of nostalgia.

Turning the page to markets, the closest we have to other-worldly things in the investment universe right now is the yield curve.

A yield curve is a line graph showing interest rates from bonds with the same credit quality and different maturity dates.  The x-axis represents years to maturity.  In a normal environment, short-term treasury debt instruments have a lower yield than long-term treasury debt instruments because longer-dated bonds must compensate investors for greater inflation risk.  A normal yield curve therefore has an upward slope.

Presently, although we have a normal (upward sloping) yield curve, it has been “flattening.”  In other words, the yield between shorter and longer Treasury Bonds is compressing.  Below is a five-year chart of the 10-year yield minus the 2-year yield.  As you can see, the flattening has been significant:

There are several reasons why this is bizarre, among them:

• High stock market valuations indicate a positive future for the economy. But, if economic growth will be robust in the future, then higher inflation and higher interest rates are likely to follow, so why aren’t longer dated Treasuries reflecting this inflation risk?
• With the S&P GSCI Commodity Index jumping 27.54% over the last year, why aren’t longer-term interest rates reflecting this indicator of topline inflation?
• If most professional investors are bullish on the stock market and bearish on the bond market in 2018, then who is buying longer dated bonds and thereby keeping yields down and prices up?
• If the Fed is going to raise rates three times this year, like they estimate, then why aren’t longer bonds following the Fed’s lead, selling off and driving yields higher?

The strangest thing about the flat yield curve is that, for the first time since the Great Recession, inflation is a potential threat.  But longer dated bonds aren’t yet reacting aggressively.  With about 6.5 million job openings and about 6.5 million unemployed, there is a true shortage of workers, particularly those with skills that align with open positions.

Wage push inflation, an overall increase in the cost of goods and services that results from a rise in wages, can be a persistent kind of inflation.  As wages rise to attract qualified workers, these pay increases tend to stick, even when the economy slows again.  Wage push inflation can create an inflation feedback loop.

The most obvious explanation for the flattening curve is that some investors foresee a slowdown they believe will stifle inflation and are investing in longer bonds thinking that as the economy slows, the Fed will ultimately reverse course and lower rates.

Regardless of what the future holds, our fixed income strategy is to exploit the flattening yield curve by building 3-4-year average maturity individual bond portfolios.  If rates continue to rise, we can reinvest maturities in even higher yielding bonds.  If rates fall, then the economy will likely have slowed, the market will have slumped and we will have a buying opportunity in equity markets.

Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.