Getting ahead of the (yield) curve
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1 Capital market insights Conversation guide May 2018 Getting ahead of the (yield) curve The yield curve has been a hot topic in the financial media recently. It is one of the best indicators of future economic conditions and market sentiment, yet many professional and individual investors do not fully understand what the shape of the yield curve means. Over the last 12 months, the yield curve has flattened as short-term rates have risen more than long-term rates. But a flatter yield curve doesn t mean an inverted yield curve or an economic recession are right around the corner. In fact, there can be good opportunities for investors even when the yield curve flattens. The yield curve offers a real-time snapshot of investors outlook for the U.S. economy. A flattening yield curve doesn t necessarily lead to an immediately inverted yield curve. Opportunities for growth still exist even when the yield curve is flattening.
2 The yield curve offers a realtime snapshot of investors outlook for the U.S. economy. The yield curve graphs current interest rates on U.S. Treasury securities across a spectrum of maturities from one month to 30 years (see chart below). A normal-shaped yield curve is upward sloping, with longer-term rates higher than shorter-term rates, reflecting market expectations for economic expansion and inflation. It s important to remember long-term rates are set by the market, while short-term rates are set by the Federal Reserve (the Fed) through monetary policy. The yield curve flattens when the Fed tightens monetary policy by raising the Fed funds target rate, which lifts the short-term end of the yield curve. Over the last 12 months, the yield curve has flattened as the Fed raised rates on the short end and investors set higher inflation expectations on the long end. An inverted yield curve represents worsening economic conditions, as investors lower their expectations for economic growth and short-term rates climb above long-term rates due to Fed tightening. 6% Chart 1: U.S. Treasury yield curves Inverted yield curve Feb. 28, % 4% 4.56% 2% Flat yield curve Apr. 30, % Normal yield curve Apr. 29, % 1.83% 0.16% 1 mo. 2 yr. 10 yr. 30 yr. Source for chart data: U.S. Treasury Dept.. Capital market insights 2
3 A flattening yield curve doesn t necessarily lead to an immediately inverted yield curve. Inverted yield curves are reliable indicators of pending economic trouble and have occurred just before every U.S. recession over the last 40 years (see chart below). While the yield curve must flatten before it inverts, there can be a long period between flattening and inversion if inversion occurs at all. For example, the yield curve flattened considerably from 1994 to 2000, during the longest and strongest economic expansion in U.S. recorded history, yet the economy did not fall into recession until The current economic expansion has a lot in common with the expansion of the mid-to-late 1990s a strong stock market, a lack of equity market volatility and robust growth broadly around the world. Chart 2: Yield difference (spread) between 10-year & 2-year U.S. Treasuries: January 1977 April yr/2-yr spread Recessions Start of yield curve flattening Bottom of yield curve inversion 3% When spread > 0%, yield curve is normal (positively sloped) 1% -1% When spread < 0%, yield curve is inverted. -3% Source for index data: FactSet Research Systems Capital market insights 3
4 A flattening yield curve is normal and can be expected at this stage of the economic cycle. We are in the ninth year of the current economic expansion and well into the late expansion phase of this cycle, when inflation pressures typically build and the Federal Reserve often tightens monetary policy, setting the stage for a flatter yield curve. Opportunities for growth still exist even when the yield curve is flattening. A long economic cycle and flattening yield curve do not mean the end of investment opportunities. For example, stocks have done well whenever the yield curve is positively sloped, even when the differences between long- and short-term rates are smaller and the yield curve flattens (see chart below). The S&P 500 has historically performed well over the following 12 months when yield spreads (the difference between short- and long-term yields) were between 0% and 1%. On April 30, 2018, the difference between the 10-year U.S. Treasury rate (2.93%) and the 2-year U.S. Treasury Rate (2.48%) was 0.45%, landing in the sweet spot for potential equity returns. Chart 3: S&P 500 forward 12-mo. returns during different yield curve periods (Jan Apr. 2018) Yield curve spread as measured by the difference between 10-year and 2-year U.S. Treasury yields 13.4% 12% 8% 8.8% 5.4% 4% When yield curve is steep (Spread > 1%) When yield curve is inverted (Spread < 0%) Source for chart data: FactSet Research Systems Current 10-yr/2-yr spread: 0.45% Capital market insights 4
5 Key takeaways The yield curve is a key indicator of economic performance and can help investors set realistic expectations for potential growth opportunities. History serves as a reliable guide the yield curve has inverted just before every U.S. recession over the last 50 years, but there can be a significant gap in time between a flattening and inverted yield curve. Perhaps more importantly for investors, stocks have performed well even during periods when the yield curve is flattening. Keep a historical perspective in mind when you hear news about the yield curve, and don t lose sight of your overall investment goals. Focus on quality companies with good fundamentals in your equity portfolio; active stock selection can be more valuable in the later stages of an economic expansion. Diversify your investments in markets beyond the U.S., where the economic cycle still has room to run and opportunities for growth may be more abundant. For more help or information, contact your financial advisor. This material is not a recommendation to buy, sell, hold or roll over any asset, adopt an investment strategy, retain a specific investment manager or use a particular account type. It does not take into account the specific investment objectives, tax and financial condition or particular needs of any specific person. Investors should discuss their specific situation with their financial professional. Except where otherwise indicated, the views and opinions expressed are those of Nationwide as of the date noted, are subject to change at any time and may not come to pass. Market index performance is provided by a third-party source that Nationwide deems to be reliable. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses have been reflected. Individuals cannot invest directly in an index. S&P 500 Index: An unmanaged, market capitalization-weighted index of 500 stocks of leading large-cap U.S. companies in leading industries; gives a broad look at the U.S. equities market and those companies stock price performance. Nationwide Funds are distributed by Nationwide Fund Distributors LLC (NFD), member FINRA, Columbus, Ohio. Nationwide Investment Services Corporation, member FINRA. Nationwide, the Nationwide N and Eagle and Nationwide is on your side are service marks of Nationwide Mutual Insurance Company Nationwide NFM-17528AO (05/18)
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