The flattening to focus on

The only thing more persistent than the flattening yield curve between two-year and 10-year Treasuries has been market fears about the flattening yield curve. Many investors are fixated on whether the flattening yield curve is set to invert–and foreshadow a recession as it often has in the past.

But this attention may be misdirected. Our latest Fixed income strategy piece, The flattening that really matters, argues that when it comes to flattening, investors are focused on the wrong curve. It is the flattening in return expectations between low- and high-risk assets taking place in the securities market line (SML) that really matters, in our view.

Expected returns on lower-risk assets have risen alongside the Federal Reserve’s policy rates, reducing the need to stretch for yield into higher-risk sectors. This has triggered volatility in the fixed income market–and underpins our defensive stance: a preference for U.S. short duration and higher-quality credit.

The SML shows the risk (volatility)-return trade-off across assets. The two SMLs on the The other kind of flattening chart below represent the yields of the broad fixed income market, adjusted for risk, for 2012–in the midst of the Fed’s quantitative easing campaign–and 2018. The 2018 trend line (green) is much flatter than the 2012 line (blue), as yields on lower-risk assets such as U.S. Treasuries have significantly increased alongside the Fed’s interest rate increases.