The Yield Curve Is Flattening, And It's Making Some Investors Nervous

Last update on May 7, 2018.

Image Credit: Mattz90 / Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also explain what a yield curve is, and why its flattening could be a concern.

 

April Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of April 2018 were as follows:

 

Last Month

Last 12 Months

Since Apr 2013

Aggressive

+0.5%

+6.8%

+98.8%

Growth

+0.4%

+5.8%

+81.9%

Balanced

+0.4%

+4.9%

+66.0%

Conservative

+0.4%

+3.9%

+51.2%

Very Conservative

+0.3%

+3.0%

+37.4%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

+0.2%

+3.6%

+37.8%

TD Comfort Aggressive Growth

+0.8%

+1.0%

+43.7%

CIBC Managed Aggressive Growth

+0.1%

+4.4%

+46.3%

Canadian Couch Potato Aggressive

+0.5%

+2.3%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free membership.

In April, Regular portfolios performed in line with our competitors. XEG.TO jumped by 12.1% during the month as oil prices continued to rise, but our portfolios’ value investing components (BRK-B and QVAL) had a poor showing.

The stock markets had a relatively quiet month in April. Anxiety over potential trade wars seems to have subsided for now, though it remains on investors’ minds. The bond market, however, had a more interesting month as interest rates kept soaring.

As you may know from reading my free book, interest rates and bond prices move in opposite directions. The Vanguard Long Term Bond Fund (Ticker: BLV), which tracks high quality US bonds, lost 2.1% in April. Canadian bonds didn’t fare much better. The iShares Core Canadian Universe Bond ETF (Ticker: XBB.TO) lost 1.7% during the month.

Now, I’m not suggesting it was a bad idea to own bond ETFs. Bonds will generally provide safety when stock prices go down, so it’s actually a good idea to own some. But it’s important to understand the risks, particularly with regards to owning long term bonds. I had written before that we would probably see inflation and interest rates rise because of U.S. government policies. I believe we are seeing the early effects of those policies.

However, the fact that interest rates are going up is not the only point of interest about the bond market. The other topic of discussion among investors is the “flattening of the yield curve”.

 

What A Flattening Yield Curve Suggests

Let me first explain what a yield curve is. The yield curve describes the difference in interest rates across bonds with different maturities. Bonds that mature a long time from now generally carry different interest rates from bonds that mature earlier. For example, a US government bond that matures 10 years from now currently pays 3% per year, whereas the US government bond that matures 1 month from now only pays 1.7% per year.

Note that this phenomenon doesn’t occur because investors are nervous about the possibility of default for bonds with longer maturities. Investors generally all believe that the US government will pay them back, regardless of whether the bond matures 10 years from now or 30. Rather, this phenomenon occurs because investors generally believe that interest rates will change in the future.

Let me give you an example of how this works. Let’s say you’re an investor, and you have the choice of buying a bond that matures in 1 year that pays 1% per year, or one that matures in 2 years that pays 1.5% per year. If the investor wanted to maximize her profit, which would she choose? The one that matures in 2 years, right? Not necessarily.

If the investor believed that the interest rate on 1 year bonds was going to go up to 3% next year, she would buy the bond that matures in 1 year. That way, she could collect 1% this year, and 3% the next, for an average of 2% per year. If she bought the bond that matures in 2 years today, she would only get 1.5% per year during the same period.

Through actions taken by such investors, the bond market tends to find equilibrium at the point where long term interest rates reflect investors’ belief of where short term interest rates are headed in the future.

As I’ve mentioned before, the general “lay of the land” of interest rates across different maturities is called the yield curve. When long term interest rates are significantly higher than short term interest rates, we say that the yield curve is steep. When long term and short term rates are similar, we say the yield curve is flat. When short term rates exceed long term rates, we say the yield curve is inverted.

For the past few years, the yield curve has generally been pretty steep.  In early 2017, for example, the interest rate of 10 year US government bonds was some 2% higher than the rate of 1 month US government bonds. However, that difference has steadily narrowed, and is currently at less than 1.5%. In other words, the yield curve has been flattening.

A flattening curve reflects investors’ belief that interest rates will rise more slowly in the future. Since interest rates tend to go up more quickly when the economy is strong, the flattening curve also expresses their belief that the economy will grow more slowly from now on.

If short term interest rates continue to go up faster than long term rates, we may eventually see the yield curve invert, which suggests that investors believe interest rates will drop. Interest rates tend to drop during economic recessions, so an inverted yield curve reflects investors’ belief that a recession is near. Investors have been accurate with such predictions in the past - an inverted yield curve predicted all 9 recessions since 1955.

The current flattening of the yield curve therefore has some investors becoming nervous that a recession will arrive in the next couple of years. To be sure, it’s not time to sound the alarm yet, as the recent trend could reverse to see the yield curve steepen. But after going through so many years without a recession, many believe we are due for one, and if the yield curve does invert, we should be prepared.

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