Download Responding to the Stubbornly Steep U.S. Treasury Yield Curve

Weekly Market U pdate
FEBRUARY 14, 2011
Responding to the Stubbornly
Steep U.S. Treasury Yield Curve
Disciplined, active investment managers are constantly on the lookout for capital
market extremes, which can provide value-adding opportunities for investors.
One such market extreme has been developing in the U.S. Treasury market for the
past three years, reaching historic levels in 2010 and earlier this year. We’re talking
about the very wide, stubbornly persistent gap between short- and longer-maturity
U.S. Treasury yields.
This market extreme is also known as the “steep U.S. Treasury yield curve.”
Picturing a Steep Treasury Yield Curve
The U.S. Treasury yield curve is simply a graph showing the yields of Treasury
securities of different maturities at a given point in time.
For example, as of the U.S. bond market’s close on February 4, 2011, U.S. Treasury
securities of the following maturities had these corresponding yields:
• 2 years: 0.76%
The U.S. Treasury yield curve
is simply a graph showing the
• 5 years: 2.28%
• 10 years: 3.65%
• 30 years: 4.74%
T
Plotting these yields and maturities on a graph, and connecting them with a line,
looks like this:
S
L
A
yields of Treasury securities of
A Wide Yield Gap and Steep Upward Slope
S
different maturities at a given
U.S. Treasury Yield Curve: Feb. 4, 2011
L
C
5.0%
point in time.
2/4/2011
Treasury Yields (%)
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0
5
10
15
Treasury Maturities (Years)
Source: Bloomberg
20
25
30
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The present “steepness” of the U.S. Treasury yield curve derives from the steep
upward slope of the line connecting the yields. This results from a relatively wide
gap of approximately four full percentage points between two- and 30-year yields.
Historically, that gap has averaged less than half that amount.
What Does the Historically Steep Treasury Yield Curve Tell Us?
The Treasury yield curve is widely considered an important leading economic indicator.
That’s because its shape and slope can tell us much about the market’s economic
expectations, particularly with regard to interest rates and inflation.
An upward-sloping yield curve is typically a harbinger of stronger economic growth,
rising inflation, and higher interest rates. For example, the presently steep upward slope
of the U.S. Treasury yield curve is based largely on the following current conditions and
market expectations:
The Treasury yield curve is widely
considered an important leading
economic indicator. That’s because
its shape and slope can tell us
much about the market’s economic
expectations, particularly with regard
to interest rates and inflation.
• The historically low level of the Federal Reserve’s (the Fed’s) short-term
interest rate target. The short-maturity end of the Treasury yield curve is often
said to be “anchored by Fed interest rate policy.” Since December 2008, the Fed’s
overnight interest rate target has been 0–0.25%, a historic low. This low rate was
in response to the credit crisis and Great Recession, designed to lower the cost of
money, stimulate lending and investment, and promote economic growth. This rate
establishes the level for most other U.S. short-term interest rates and yields, including
the prime lending rate for banks, money market yields, interest rates on certificates
of deposit, and the two-year Treasury yield. As long as the Fed views recession and
deflation as a greater potential threat to the U.S. economy than inflation, it will keep its
rate target low.
• Expectations that Fed and U.S. government policies to stimulate the economy
could eventually be inflationary in the longer term. The sheer magnitude of the
Fed’s and the U.S. government’s stimulative monetary and fiscal policies in the wake
of the credit crisis and Great Recession have fueled inflationary expectations. For
example, the Fed’s low interest rate policy described above helped end the crisis and
recession, but at the risk of inflating other asset bubbles—possibly in commodities
and stocks—similar to the housing and finance bubbles that led to the crisis and
recession. Aggressively low interest rate policies also risk devaluing the U.S. dollar
and fueling significantly higher “imported inflation” down the road. Inflation
expectations are among the key risk factors priced into longer-maturity Treasury
yields—whenever you see longer-maturity Treasury yields that are significantly
higher than shorter-maturity yields, you can typically assume that higher inflation
expectations have been priced in.
Picturing the Relative Magnitude and Persistence of the Latest Steep Curve
Two factors that distinguish this particular period of Treasury yield curve steepness are:
1. Magnitude. The yield gap between two- and 30-year Treasury securities had never
before broached 4.0 percentage points.
2. Persistence. Instead of broaching 3.5 percentage points for a short time and then
declining, as it did following the recessions in 1990-91 and 2001, the yield gap
peaked twice more in the latest period and has remained near 4.0 percentage points.
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These distinguishing factors are displayed in the following graph, which puts the latest
curve steepness into a larger historical context, over the last 22 years:
The Latest Yield Gap Has Been Wider for a Longer Period
2- to 30-Year Treasury Yield Gaps: Feb. 1989 to Feb. 2011
Yield Gap (Percentage Points)
5.00
4.00
3.00
2.00
1.00
0.00
level of steepness, what’s
most likely to happen next,
statistically, is that the
Treasury yield curve should
eventually start to flatten.
Feb 11
Feb 10
Feb 09
Feb 08
Feb 07
Feb 06
Feb 05
Feb 04
Feb 03
Feb 02
Feb 01
Feb 00
Feb 99
Feb 98
Feb 97
Feb 96
Feb 95
Feb 94
Feb 93
Feb 92
Feb 91
Feb 90
At this extreme, historic
Feb 89
-1.00
Date
Source: Bloomberg
Why did the Treasury yield gap recently exceed 4.0 percentage points for the first time
and stay stubbornly above 3.5 percentage points? Blame primarily the Great Recession
and its aftermath. As we mentioned earlier, the short-maturity end of the curve has been
anchored by the Fed’s refusal since 2008 to change interest rates, which could continue
until 2012.
Meanwhile, since September 2008, the Fed and the U.S. government have also
unleashed additional, unprecedented levels of stimulative measures on the U.S.
economy, financed largely by soaring federal debt levels and increased Treasury debt
issuance. This has put devaluation pressures on the U.S. dollar and stoked future
inflation fears. All those risk pressures on long-maturity Treasuries, combined with the
Fed’s interest rate lock-down at the short-maturity end of the spectrum, has helped
produce an environment conducive to a larger, more-extended yield gap.
What Could Change the Slope of the Treasury Yield Curve?
At this extreme, historic level of steepness, what’s most likely to happen next,
statistically, is that the Treasury yield curve should eventually start to flatten, as we can
see from what happened after curve steepness peaked in October 1992 and July
2003. This typically can occur in a couple of ways:
• A “bear flattener.” This is when the Treasury market anticipates that the Fed will
begin raising its overnight interest rate target, and begins pricing in significantly higher
short-maturity yields. This is a “bearish” scenario because the upward adjustment in
yields usually translates to price declines for most fixed income securities. Meanwhile,
longer-term yields may also move up, but they generally hold relatively steadier than
short-maturity yields as the Fed’s actions are perceived to be a start in the direction of
addressing long-term inflation threats. This is typically the most common yield curve
flattening scenario at the point we’re now in during the business cycle, when the Fed
is poised to raise its interest rate target after years of low rates.
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Active investment managers,
such as those at American
Century Investments, have
been looking at potential
changes in the extreme,
historically steep Treasury
yield curve as an opportunity
to add value for clients.
•A
“bull flattener.” This is when economic weakness, a declining threat of inflation
ahead, and/or a geopolitical or financial threat that feeds a flight to credit safety
drives bond buyers/safety seekers back to the longer-maturity end of the Treasury
market, causing longer-maturity Treasury yields to decline more than shorter-maturity
yields. This is a “bullish” scenario for bonds because Treasury prices typically increase
under this scenario. This scenario can occur—as it did in the middle of 2010—when a
recovering economy is still finding its legs and suffers a temporary setback or threat.
Last year, it was primarily the European sovereign debt crisis that caused the mid-year
bull flattener. This year it could potentially be the revolutionary turmoil in the Middle
East, sharply higher oil prices, or some other similar disruption.
Applying Curve Expectations to Active Fixed Income Strategies
Active investment managers, such as those at American Century Investments, have
been looking at potential changes in the extreme, historically steep Treasury yield curve
as an opportunity to add value for clients, particularly at a time when bond yields are
relatively low and the risk of bond price declines from rising interest rates has increased.
While past performance is no guarantee of future results, and it’s still possible that
the curve could steepen further, American Century Investments’ fixed income team
believes strongly that over the next few years, the most likely yield curve behavior will be
flattening, accompanied by narrower Treasury yield gaps.
Based on this conviction, our fixed income team began implementing small, incremental
“yield curve flattening bias” trades in bond portfolios in 2009. The Treasury yield curve
version of this strategy involves selling two-year Treasury futures short (anticipating
declines in value as interest rates rise) and buying 30-year Treasury futures long. (For
shorter maturity/duration portfolios, the fixed income team sells two-year Treasury
futures short and buys five-year futures long.)
The goal is to achieve a certain percentage of positive portfolio return for every curve
flattening move. It doesn’t matter if it’s a bear flattener or a bull flattener. For example,
the mid-year bull flattener enhanced American Century bond portfolio returns during
2010. But, conversely, resurgent yield curve steepening in the fourth quarter of 2010
counteracted those gains. Curve changes can be volatile and unpredictable in the nearterm, particularly at inflection points for the economy. This positioning requires long-term
conviction and commitment to succeed.
What Does All This Mean for Investors?
The increasing likelihood of Treasury yield curve flattening and higher interest rates and
yields across the maturity spectrum in the coming two to three years means looking at
fixed income portfolios and evaluating how they are positioned and managed for that
longer-term scenario. It’s worth noting that actively managed portfolios that pursue yield
curve strategies can supplement more typical duration, sector, and credit management
strategies. As economic conditions improve and bond portfolios face more inflation and
interest rate challenges, it’s a good time to assess what tools fixed income managers
have ready and available in their toolboxes.
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Past performance is no assurance of future results. Investment return and principal
value will fluctuate, and it is possible to lose money by investing. In addition, generally,
as interest rates rise, bond prices fall.
You should consider a fund’s investment objectives, risks, and charges and
expenses carefully before you invest. The fund’s prospectus or summary
prospectus, which can be obtained by visiting americancentury.com, contains
this and other information about the fund, and should be read carefully before
investing. Investments are subject to market risk.
The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any
American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
©2011 American Century Proprietary Holdings, Inc. All rights reserved.
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