Yield curve musing: The real signal

Inflation adjusted, curve inversion is in sight. What are the implications?


In one chart (Feb.): The yield curve flattens as growth set to slow:

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  • The yield curve is often seen as the single best recession indicator for the US. Since a US recession also implies a peak in global equities, the current market obsession with the yield curve needs no further explanation. If the curve inverts, a US recession is within reach, if not – so the saying goes – investors can relax. Although it has flattened considerably, the nominal yield curve (the difference between 10 and 2 year US government bond yields) is still 0.5 %-pts. away from inversion at the time of this writing. No inversion, no worries? We think the picture is not that simple…

 

  • First, note why the US yield curve matters: It is an early indicator for the credit cycle. Longer dated bonds reflect growth and return potentials. Short dated bonds are a proxy for the monetary policy stance and financing costs. Consequently, if short yields are low and long yields high, it makes a lot of sense to borrow and invest as the credit cycle is vibrant, supporting growth and inflation. If it is the other way around, investments are less attractive and credit risky. The economy slows in a deflationary spiral. Ad extremum (read: Inversion) a recession follows.

 

  • Secondly, the yield curve should not be seen as a 1-0 variable – the degree of flattening matters as well, not just if it is inverted or not. In order to see, let’s focus on the real (i.e. inflation adjusted) yield curve, as we ultimately care about real The US real yield curve is at the flattest level in more than 10 years, only 10 basis points shy of inversion. In real terms, the flattening already happening indicates that growth should slow from here as the credit cycle is turning and a flatter curve should lead to tighter lending standards. This might be a key reason why forward markets are already pricing the end of the Fed’s hiking cycle, as 3-year forward rates are lower than 2-year forward rates.

 

  • Third, the flattening real yield curve carries important market implications: As a turning credit cycle as such is deflationary, there should be limits to how much US long-term rates can rise, despite the short-term uptick in inflation. And as growth is still revised up, disappointments are likely. Safe and liquid income generating assets are increasingly needed. Ignore the real yield curve at your peril.

 

This is a Nordea Asset Management macro view, not the official Nordea view.

 

 

About Nordea Asset Management

Nordea Asset Management (NAM, AuM 216.5 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 320.1 bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

 

*Source: Nordea Investment Funds, S.A., 31.03.2018

Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A. and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and representative offices. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Investments in equity and debt instruments issued by banks could bear the risk of being subject to the bail-in mechanism (meaning that equity and debt instruments could be written down in order to ensure that most unsecured creditors of an institution bear appropriate losses) as foreseen in EU Directive 2014/59/EU. Nordea Asset Management has decided to bear the cost for research, i.e. such cost is covered by existing fee arrangements (Management-/Administration-Fee). Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are licensed and supervised by the Financial Supervisory Authority in Sweden, Finland and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and representative offices are licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source (unless otherwise stated): Nordea Investment Funds, S.A. Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and representative offices. This document may not be reproduced or circulated without prior permission. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or representative offices.

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