When the Yield Curve Flattens

The flatness of the yield curve and what it means remains a hot topic in my conversations with clients and other investors. One question I'm starting to get more and more is this: "If short-term bonds yield about as much as long-term bonds, why take the risk of owning long-term bonds?" I understand this temptation, but please dear reader, read below before doing anything rash! Also today a quick update on my bull USD call. Might be time to take some chips off the table.   Risk cuts both ways The first order thought behind the question above is very simple. Longer-term bonds are more volatile, and as a general rule investors prefer things that are less volatile. Plus if you buy something like a 3-month T-Bill, you really can't lose money. If you buy a 10-year bond you can definitely lose money. So in this sense longer-term bonds are riskier. Hence if we were to get to a place where T-Bills yielded the same as 10-year Treasuries, your first instinct might be to just own Bills.   But if you take this concept of risk to the next level, you realize that T-Bills have risk too. What if general interest rates fall and you missed out on the opportunity to lock in higher rates by buying a long-term bond? I.e., you have to reinvest   This point is particularly relevant when you consider why the yield curve flattens...   The market is telling you that short-term rates are going to fall The yield curve flattens as the Fed hikes. The yield curve slope tends to reach zero when the market thinks the Fed is about done hiking. It tends to invert when the market expects the Fed to cut. Hence if you buy short-term bonds at a moment when the curve is at zero or inverting, you should expect to reinvest at lower rates. Hence the relatively high short-term rate is illusionary. You won't actually earn that yield over any reasonable time horizon.   This has played out historically I went back to the last six times the yield curve got to a zero slope between the 2-year and 10-year Treasury. In each case I took the moment when the 2-10 curve first hit zero and then measured what an investment in the 10-year Treasury would have produced. One caveat is that the curve got to almost zero in 1984 and 1994, so in those two cases I took where it fell below 20bps. Here's what happened.     You can see from the table that the moment of hitting a flat curve isn't always a top in rates. The 3-month return is about a coin flip as to whether you make money or not. But going out a year or more, you become very likely to profit. This makes sense: if the yield curve is actually a harbinger of a recession, interest rates are going to tend to fall. Plus it takes a year or two for a flat yield curve to turn into a recession, hence why a year or two out, you tend to make money on the curve inversion.   Whether or not longer Treasuries outperform cash is a matter of how deeply inverted the curve becomes and how long it takes before the Fed starts cutting. In the early 1980's, the curve became more than 150bps inverted, which gave the cash side of this trade a big advantage. Plus the Fed was trying hard to fight run-away inflation, keeping short-term rates relatively high. Hence cash did very well during that period. But in all cases, by the time you give the economy enough time to slow, eventually rates fall enough to overwhelm the cash return.     It remains a good time to own bonds Readers of this space know I've been a big fan of flattener trades as well as staying long bonds overall. While eventually the curve will get flat enough that I don't like this trade, as long as the Fed keeps hiking, I'm staying in a flattener. And eventually the history above will cause longer-term rates to fall, and I'm happy to get paid while I wait.   Meanwhile... USD at resistence While I'm sticking to the trade recommendations I've had out there, it does look like my long USD position has reached a resistance point. DXY is overbought and BPS and EUR are oversold. My main thesis on being long the dollar is based on the US tightening monetary policy faster than the rest of the world. That has been playing out, but the turmoil in Turkey/Argentina has put an accelerant on USD strength. That could easily dissipate and get a minor USD sell-off. I'm cutting my position in half until the overbought situation resolves itself. However I'm still long-term bullish on USD, so I'm not going to let it go completely.      
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