Yield Curve Disinversion

The title of this newsletter may not be conducive to light holiday reading on the beach. It is, however, a crucial top-down description of how tectonic plates may be changing in fixed income markets, and especially in the most important of them all – the US Treasury market. It is also an indication of how the Federal Reserve does not shirk from adopting innovative policies when faced with the consequences and dangers of their actions in the last two years to bring down rates of inflation, with one foot on the accelerator and the other on the brake simultaneously.

Despite some areas of inflation remaining stubbornly high, it is generally accepted by markets, market participants and central banks that the aggressive monetary policies are having the desired effect of curtailing further inflationary pressures, even if the outcome would be that short-term interest rates are destined to remain higher for longer, whatever that means.

Pockets of the media continue to opine that markets are wrong and that the worst is yet to come as inflation remains far from conquered and that the recession is pushed back temporarily. The usual arguments prevail, ranging from the death of globalisation to the replacement of just-in-time supply chains with “just-in-case”, for reasons of security. In the real world, however, commercial deftness is more likely to preserve free trade around the world, even in times of war.

It has become evident during the month under review that the Chinese economy is faced with important problems. As that economy balances Communist Party interference (and the fact that all major banks are controlled by the state as shareholder) with the required modicum of a free market; and as it is generally accepted that Chinese economic data are not amongst the most reliable, the observer can quickly conclude that the Chinese central bank’s monetary policy, recently announced, amounts to too little too late, as the world’s second largest economy slips back into deflation. Nonetheless, however, the central bank of this important economy has continued down a path of further falling interest rates.

According to the Swiss daily newspaper NZZ, the six main problems China is confronted with range from: a bursting real estate bubble; the pretext ofnational security that produces rules seen as unfriendly towards investors; weak domestic consumption that no longer fuels economic growth;  bad capital allocation that has led to high national debt levels; the demographic trap as birth rates have fallen dramatically; a hopeless young generation as youth unemployment is rampant.

But the real action has taken place in the US. The generally held view now has it that the Goldilocks scenario of moderate growth, and no recession, is accompanied by falling rates of inflation and a Federal Reserve that is preparing to cease its monetary tightening in the foreseeable future.

However, if a recession will be avoided as inflation sinks back to levels tolerated by central banks, markets are wondering whether the inverted yield curve that has accompanied investors over the last few years is still appropriate. And the hectic activity in this crucial market experienced during the quiet August weeks appears to signal that an unwinding of the inverted yield curve, or disinversion, is currently taking place. Trend shifts are often first triggered by technical factors such as a squeeze in liquidity before turning fundamental. Even if this is the case now, it will still have multiple side effects both macro-economically and within the indebted corporate and private communities.

Of key importance has been the announcement by the US Treasury that investors can expect a surge in longer-dated bond supply, not least as a catch-up effect of the freeze in issuance while negotiations were taking place to prolong the debt ceiling a few weeks ago. That Fitch downgraded the US’s ratings did not help.

Another complicating factor has been the Fed’s messaging whereby quantitative tightening, or QT, will proceed alongside any expected relaxation of monetary policies, potentially starting next year. With both the Fed and the US Treasury thus increasing long bond supply at a time when disinversion has commenced, this has complicated an already complicated picture further, as well as not having been experienced by the current generation of investors.

Quality Growth share prices have taken a breather in the month under review, influenced by the factors described above. Investors in this space will be reassured, in spite of risen yields and disinversion taking place, that their Quality Growth businesses operate outside fixed income markets as the growth is largely organic. For such investors, the potentially new normal of ten-year bonds in excess of 4 per cent is not likely to affect all the other of the Ten Golden Rules that underpin the quality of their growth businesses. The journey from quasi-zero yield to the current level has been speedy and brutal, but the brunt of share price and valuation declines took place in the early stages of inflation and interest rates alignment, with valuations today back to attractive and reasonable levels.

August has a habit of making life difficult for investors as they attempt to distract themselves from the goings on in financial markets. With the advent of September, normality returns….

P. Seilern,

August 22^nd, 2023

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