It Is Time to Move Down the Yield Curve

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The business cycle has progressed to the point where the front end will outperform the long end of the yield curve.

In the last three recession eras (cycles 1-3 in the chart below), yields at the front end of the yield curve moved lower more than the long end of the yield curve, by a lot – an average of 1.8 times as much. This happened because as the Fed lowered rates during those recessions, the front end of the yield curve (e.g. the 2-year U.S. Treasury) followed changes in the lowered Federal Funds rate, while the long-end of the yield curve began to anticipate the stimulus of lowered rates having a positive future effect, causing them to fall less.

In bond lingo, the yield curve steepened.

Because of this, holding duration-equivalent amounts of 2-year Treasuries (using leverage) will outperform the rest of the U.S. Treasury yield curve in a recession-era environment. In recent articles, I have advocated holding positions primarily at the long end of the curve. But enough evidence exists to begin moving U.S. Treasury exposure forward on the curve. Let me explain why.

A less hawkish Fed means inversion may not happen

The chart below shows the difference between the 30-year and 2-year yields over time. Quite simply, when the line rises, it is a better time to own the 2-year; when the line falls, it is better time to own the 30-year (assuming equal amounts of duration exposure). During recession eras (cycles 1-3), the line tends to go up.

In the past three cycles, this line fell below zero (yield curve inversion) before it turned around and went up. The yield curve inverted because the Fed raised rates above the rate of the 30-year before everything turned around. Currently, the 30-year yield is 45 basis points above the 2-year yield (as of 1/28/2019).