Why the shift in the US yield curve means investors need to be nimble

Now, fast-forward to today; the yield curve is gradually reverting to its conventional shape as long-term interest rates surge. Since June, the interest rates on 10-year, 20-year, and 30-year US Treasury bonds have risen by approximately 1 per cent.

The hitch lies in this shift toward a steeper, or less inverted, yield curve. A soft landing is regarded as economic nirvana, where rate hikes alleviate inflationary pressures and nudge the economy toward optimal growth without necessitating further adjustments.

However, the steepening yield curve is reducing the possibility of this idyllic scenario.

The reduction of yield curve inversion from rising long-term rates, in tandem with inflation slowing toward central bank targets is an unusual outcome. Real yields (10-year rates minus inflation) have skyrocketed to their highest level in 15 years, surging 3.5 per cent since their nadir in 2021.

Elevated longer-term rates not only usher in higher borrowing costs for consumers and businesses but also for the government itself. The recent fiscal policy expansions could prove unsustainable with the mounting US government debt being financed at these elevated rates. As I often say, “the world can’t handle higher interest rates,” and this sentiment is truer now than ever before.

As rising long-term yields pave the way for a normalised upward-sloping yield curve, central bankers may find themselves compelled to lower
rates in response to the recession that may stem from these persistently higher rates.

The economy’s resilience amid steep rate increases over the past 18 months has been commendable but highly unusual. This colossal surge in real yields introduces new risks unseen since the pre-global financial crisis era.

Be wary of probabilities

Our perceptions of event likelihoods and their unfolding are profoundly influenced by biases and recent experiences. Author Michael Lewis’ book The Undoing Project delves into the intriguing collaboration between psychologists Amos Tversky and Daniel Kahneman, whose research laid the foundation for behavioural economics.

Their work illuminates the common judgment errors people make when predicting outcomes, emphasising how personal experiences often carry more weight than objective data. Remarkably, individuals can misconstrue a prediction with a 51 per cent probability as a sure thing.

Anticipated outcomes can take unexpected turns, even when predictions ultimately materialise. Last weekend treated us to two of the most thrilling grand finals in Australian sports history. Both the AFL and rugby league matches were nail-biters, with lead changes happening until the final moments. The final results hung in the balance until the last sirens blared.

In these games, there was never a moment of absolute certainty that either Collingwood (AFL) or Penrith (rugby league) would emerge as the premiers, despite both teams being favourites to win since June.

Sporting events offer a front-row seat to the rollercoaster of changing win probabilities in real time. You can witness this live through betting odds or spreads on sports websites during live broadcasts.

Similarly, the New York Federal Reserve calculates a monthly “probability of recession in the next year” index based on the slope of the yield curve. Before the recent shift in US bonds, the yield curve’s inversion was the most pronounced in over four decades, and the Fed’s model computed the probability of a recession at around 70 per cent.

The model’s rationale is that if markets anticipate steep rate cuts in the
future, it’s a response to an expected growth shock or recession. Ironically, higher long-term rates and real yields could introduce more significant challenges for the global economy and trigger a growth shock.

Over the past three years, we’ve witnessed a transformation in economic outcomes, market behaviour, and the dynamics among various assets. This recent period diverges significantly from the preceding two decades, ushering in a new economic paradigm.

Market forecasters who assert absolute certainty about the future can misguide investors when they miscalculate the path to that outcome. This is where defensive alternative strategies come into play, offering positive returns untethered from traditional market patterns. These strategies excel at analysing new market scenarios without the shackles of fixed biases when confronted with unforeseen circumstances.

In today’s landscape, it’s imperative for investment managers to prioritise risk comprehension, consider probabilistic scenarios, and remain adaptable to fresh data.

Looking forward, I anticipate that the yield curve will revert to a more conventional shape as my bias is that the Fed will start cutting rates aggressively within the next six to 12 months. However, if a steeper curve is driven by even higher long-term interest rates, it will significantly elevate the likelihood of a recession, irrespective of the New York Fed’s models.

This underscores the need for a defensive stance and the inclusion of defensive alternatives in investment portfolios. Staying nimble and prepared for the unexpected is the key in these ever-evolving financial markets.