Are Bond Yields Signaling a Recession? | Capital Group

World Markets Review

November 2017

Are Bond Yields Signaling a Recession?

“As equity markets have rallied, plan sponsors have rebalanced from equities to LDI.”

Wesley K. Phoa Portfolio Manager/Analyst Los Angeles office 21 years of experience (as of 12/31/2019)

In this month's LDI market commentary:

  • November’s Treasury market trading
  • Credit outlook for real estate companies
  • Interpreting the signs from a flattening yield curve

Bond Market Activity

Bond yields drifted higher in November, driven by signs of an improving U.S. economy and renewed optimism for tax reform. U.S. economic data came in mostly positive as better consumer spending and industrial production offset softer durable goods orders. Near the end of the month, expectations that Congress would approve major tax reform legislation sent the 10-year Treasury yield above 2.40%. Equities hit a series of record highs.

The yield on the 10-year Treasury note rose 4 basis points to 2.42% — still well below the 2.60%-plus levels last seen in March. The benchmark bond is on track to finish 2017 roughly where it started, hovering around the 2.40% level. Investment-grade credit spreads widened 2 bps to 97 bps.

Sector Outlook ― Real Estate

The real estate industry has been relatively benign in recent years. Companies have been focused on strengthening their balance sheets so they are easily able to deal with and hopefully find opportunities in the next downturn. Management teams still remember the 2008 crisis and want to be prepared the next time the commercial real estate cycle moves against them. At the same time, development

Industrial real estate companies are experiencing their best-ever fundamentals. Growing e-commerce and the need to get to the consumer quickly are creating strong demand for industrial space. This is a trend not only in the U.S., but globally as well. Many industrial real estate stocks are close to all-time highs, and bonds are relatively rich. Retail real estate is the sub-sector that is struggling the most. Supply has been muted and headwinds are likely to persist. Retailers and retail formats change every 10 years, and we are seeing a lot of change today.

At the same time, the growth in online activity is hurting brick-and-mortar retail as it is reducing demand for space, mainly in lower quality assets in tertiary locations. It’s not the end of the shopping mall, but the mall needs to change. Companies that have changed the mall to be more of an experience with more entertainment and food are seeing much better foot traffic and growing demand for space from retailers, but not all locations will be able to adapt to the changes so easily. We are starting to see attractive opportunities in the retail REIT space, but investors must understand the assets and locations well to determine which ones are likely to succeed in the years to come.

Structural Issues — Yield Curve Signals

As While the yield curve has flattened more rapidly than implied by the forward curve over the past six months, this flattening move has been most pronounced since October. A number of explanations have been proposed, some related to supply and demand, and others to economic fundamentals.

The most plausible supply/demand explanation is related to plan sponsor behavior. As equity markets have rallied, DB plan sponsors have been rebalancing from equities to LDI. In addition, some plan sponsors have been making contributions in anticipation of tax reform: if the corporate tax rate is expected to fall, it is more beneficial to make tax-deductible contributions at today’s higher tax rate.

The most plausible economic explanation is related to monetary policy. As late cycle wage and price pressures build up, it would be normal for Fed tightening to accelerate. Indeed, in almost all past cycles, the Fed ended up tightening faster than expected towards the end of the expansion. This explanation is somewhat consistent with the Fed’s own “dots,” but not with shorter maturity bond yields. (Another explanation would be that the inflation risk premium has declined sharply — perhaps because the Fed is perceived as more hawkish — but this is inconsistent with the behavior of TIPS.)

There has been some concern that the yield curve flattening is signaling a recession, but this seems premature. First, the yield curve is still quite far from flat, much less inverted. Second, the reason that past yield curve inversions were followed by recessions is because the Fed tended to hike too late and then too aggressively. The inverted curve was a symptom, not a signal.

(Portfolio managers Wesley Phoa and analyst Robert Caldwell contributed to this report.)

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