Featured # Markets | 2 years ago

Are Bonds Giving Investors Too Much Confidence?

According to reports, the yield curve, which is a measure of the difference between long and short term rates, is considered a guideline of economic strength. Basically, the longer period of time that an investor will hold a bond, the higher the annual yield could be. Now this is done in order to actually compensate that investor for potential inflation and any missed chance to create wealth in other places. But if longer term bond yields are closer to shorter term bonds it can be a possible signal that there is less inflationary fear and less positive outlook for other asset classes—IE the overall economic market and the confidence in consideration.

The yield curve on the U.S. 2-year treasury not and 10-year Treasury note inverted before the last three recessions. It actually turned negative in advance of the downturn. On Monday, the spread between the 2 and 10-year bonds fell and some investors may have found solace in the fact that the yield curve remains above zero.

Analysts however, paint a different picture. Bank of America Merrill Lunch has pointed to a glaring problem from holding too much confidence from one simple indicator. “Taken at face value, this may suggest recession odds are small. However, we argue this logic is flawed because the curve is structurally steep when the Fed Funds rate is close to zero. When adjusted for the proximity of rates to zero, the curve may already be inverted and therefore might signal a recession,” Ruslan Bikbov of BofAML wrote in a Monday research note.

If the fed funds rate remains under 1 percent, the yield curve most likely will not invert even during a recession. This is simply because it would almost be impossible for longer term yields to dip under those extremely low levels, according to Joseph LaVorgna of Deutsch Bank. ‘We believe there is a high probability that whenever the next US recession occurs, the 10s-fund curve is likely to remain positive, and perhaps significantly so, at least compared to past business cycles,” LaVorgna wrote to clients at the end of January.

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