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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly asset allocation report for October 14, 2024. I'm Phil Adler. Does the recent uninversion of the yield curve create an opportunity on the long end for bond investors? Confluence chief market strategist Patrick Fearon Hernandez joins us today to take a look. Patrick, for so long we're told that an inverted yield curve, such as we've experienced for so many months, was a reliable indicator of a recession.
Phil Adler:And now the yield curve has uninverted, with the 2 year treasury yield falling below the 10 year yield. Before we get into the implications for investors, do you think this recent oninversion might not have received the attention it warranted?
Patrick Fearon-Hernandez:Hi, Phil. Thanks for having me on the program. To answer your question, yes. I'm a little surprised that the financial media isn't talking about the uninversion as much as I would have expected. Granted, there are lots of competing stories out there right now, such as the risk of war in the Middle East, the Chinese economic stimulus, and the like.
Patrick Fearon-Hernandez:And maybe after such a long period of having the yield curve inverted with no recession, reporters have decided it just isn't important anymore. All the same, uninversions have historically been important, so we decided to examine the potential implications of this one.
Phil Adler:Are you on board with the idea that that the inverted yield curve this time around lasting 25 straight months was a false indicator of recession?
Patrick Fearon-Hernandez:Well, it certainly looks that way to me. Despite having the yield curve inverted all that time, there are only limited signs of a potential economic recession coming up. Economic growth has certainly slowed, and you could probably make the argument that lower income households may be in recession themselves. But the overall economy is still growing nicely. Is it a surprise that the yield curve appears to have been a false indicator of recession this time?
Patrick Fearon-Hernandez:Not necessarily. Remember, lots of traditional economic indicators and financial relationships have behaved weirdly in the pandemic and post pandemic eras. The last 5 years or so have been unique, so it shouldn't be a surprise if some old rules of thumb just don't hold right now.
Phil Adler:Patrick, why might the current environment and the recent uninversion be considered a positive one as some analysts feel for longer term bond
Patrick Fearon-Hernandez:values? Well, for a lot of investors and commentators, the basic idea is that the uninversion stems from the Federal Reserve finally starting its interest rate cuts. Many commentators and investors are looking for the Fed to cut rates quickly or over an extended period. That idea was buttressed by the Fed's big 50 basis point cut to start the cycle. And now despite the recent good economic data, some people are worried about the economy slipping into recession, and that would also support the idea of aggressive rate cuts.
Patrick Fearon-Hernandez:The assumption is that such a dramatic cut in the Fed's short term interest rate would eventually have to bring down longer term bond yields as well, resulting in a boost to longer term bond prices.
Phil Adler:Now as you took a closer look at this, Patrick, how did you go about testing this?
Patrick Fearon-Hernandez:Well, in the analysis discussed in our recent report, we simply looked at the last 8 yield curve uninversions going back to the 19 sixties and examined the total returns provided by 5 year 10 year treasury obligations in the year after each of them. So since many strategists are advising people to lengthen their bond maturities because of today's uninversion, we wanted to see if historical experience really supported that idea.
Phil Adler:And what did you find?
Patrick Fearon-Hernandez:Well, the historical record is really interesting. In the year after the uninversions, both 5 year and 10 year treasuries provided a modest positive return on average. But that experience wasn't uniform. After 6 of the uninversions, 5 year and 10 year treasuries provided positive returns that were mostly in the mid single digits, so they generally weren't spectacular. However, after 2 of the uninversions, those longer term treasuries provided negative returns.
Phil Adler:What was the deciding factor?
Patrick Fearon-Hernandez:The analysis suggests that the key variable is the trajectory of the Fed's benchmark short term interest rate in the year after the uninversion. To the extent that the Fed funds rate declines in the year after an inversion, total returns for longer term treasury obligations have been greater. If the Fed funds rate is basically stable in the year after an inversion, investors' total returns from longer term treasuries have been similar to the yield on those obligations. But if the Fed funds rate increases in the year after inversion, the total return on longer term treasuries has typically been negative.
Phil Adler:Well, the consensus, Patrick, among market forecasters is that the Fed will keep cutting the Fed funds rate. The debate is over how much and how quickly. Would quicker and deeper then be the more positive scenario for longer term bond values?
Patrick Fearon-Hernandez:Yes. That's what the analysis suggests. And that seems to be the underlying assumption of those who are advocating a maturity extension strategy at this point. They seem to be assuming quicker and deeper rate cuts, perhaps associated with an impending recession.
Phil Adler:On the other hand, if the economy does achieve a soft landing and the Fed takes the moderate road on further interest rate cuts, longer term bond values would be less attractive right now?
Patrick Fearon-Hernandez:Yep. That's our point. If the Fed instead takes a higher for longer approach to interest rates, that maturity extension trade just doesn't look so attractive. And if the economy really surprises to the upside, forcing the Fed to hold rates steady or even start raising them again, the trade looks downright bad.
Phil Adler:And which road do you think the Fed is more likely to follow?
Patrick Fearon-Hernandez:Well, we do acknowledge that US economic growth has moderated, making it potentially more susceptible to recession if there's an outside shock of some kind. However, there's still a lot of economic momentum here. The recent strong employment report for September underlines that view. As a result, we think the Fed's interest rate policy from here will be higher for longer, expressed as slow rate cuts and a terminal rate that may be higher than most observers expect. And again, the implication of that is that the maturity extension trade may not be such a great idea.
Phil Adler:What part of the yield curve does Confluence Investment Management currently consider more attractive?
Patrick Fearon-Hernandez:Well, of course, the exact place depends on the investor's risk tolerance. Nevertheless, we generally prefer the standard short term stance with an average duration in the range of something like 2 to 3 years.
Phil Adler:And remind us, Patrick, where do longer term bonds reside within Confluence asset allocation models?
Patrick Fearon-Hernandez:Well, none of our asset allocation models has any long term bond exposure right now. Our most conservative models do have some intermediate term exposure, but our most popular growth and income strategy is strictly in short term bonds. In the next couple of weeks, we'll be doing our regular quarterly update to the models, so that could change a bit. Nevertheless, I suspect we'll still favor shorter term exposure over longer term exposure based on the analysis we're discussing today.
Phil Adler:Finally, Patrick, is now the time do you think to reduce money market assets in favor of
Patrick Fearon-Hernandez:bonds? Well, first of all, within all of our asset allocation models, we only keep a minimal 1% exposure to cash. Now more broadly, however, we do recognize that there is a huge amount of investor assets in money markets these days as people try to take advantage of the recent high interest rates while minimizing risks. Nevertheless, if the economy remains as healthy as we think it is and if the Fed cuts rates even a modest amount, you could well see a massive reallocation out of money market funds and back into stocks or other risk assets going forward. It's hard to predict exactly when that could happen, but we do think that it's a distinct possibility.
Phil Adler:Thank you, Patrick. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Ledner.