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Written by: Matthew Sheridan
The current slope of the US Treasury yield curve is inverted. Two-year yields are higher than 10-year yields, and to us that means that investors are focused on a few things.
First and foremost, the Fed is likely to continue to raise interest rates in the near term. Last year, the Fed raised 425 basis points. Markets expect the Fed to raise another 25 in February, another 25 basis points in March, and that means that investors are continuing to price upward pressure on the short end of the yield curve.
The second thing that the inversion of the US yield curve tells us is that investors are worried or increasingly worried about a slowdown in US growth in the near term, meaning second half of 2023, highly likely that the US economy moves much closer toward 0% growth or recession.
We’re starting to see a slowdown in interest-rate-sensitive sectors, most pronounced in US housing. And if that continues, that will likely bring forward the ending of the Fed raising rates and likely, eventually, the Fed actually running countercyclical monetary policy, meaning that they’re going to lower overnight funding rates.
To us, that plays out in a few different ways. One, you want to be liquid in that environment. You want to be a little bit overweight duration in case US growth does slow faster and more than what people, base-case expectations, lay out. Three, you want to be diversified across your different sectors. You want to own some high yield.
You want to focus on higher-quality high yield. We don’t expect defaults to increase meaningfully, but if we’re wrong about that, you want to limit how much potential default risk you have by having less triple-C-type exposure. Emerging markets also make sense. They are the one sector that offers meaningful pickup in spread terms compared to the long-term average.
We also find it attractive to own US securitized assets, both commercial real estate and residential. In the US, residential assets have all the prior house price appreciation built in, which means the LTVs or loan-to-value have delevered pretty aggressively in the last four or five years. Potential default risk in housing is extremely small.
And so for us, the shape of the US yield curve means be liquid, own some duration, diversify your income exposure across sectors. You can play offense here. If and when the Fed starts to pull back, the return opportunity will look quite attractive for income-sensitive assets in 2023.