The Flat Yield Curve

April 17, 2018  | By Kevin Smith

Here is what has been going on in global markets in Q1 of 2018. Click here for the full Q1 report in PDF format.

Some interesting facts from the Q1 report:

• Top performing emerging markets: Egypt, Brazil, Peru, Russia
• Most appreciated currency: Mexican Peso +7.19%
• Worst performing broad asset category: US Real Estate -7.43%
• Crude oil +8.4%

Something else worth noting is the yield curve is almost flat!

What is a yield curve? It is a chart that shows interest rates for loans ranging from very short-term to very long-term. A ‘flat’ yield curve means short-term interest rates are similar to long-term interest rates. It is usually the case that investors are rewarded for lending their money for longer periods of time, so this curve usually slopes upward.

How did the yield curve become flat? Short term interest rates increased 1% since last year, while long term interest rates are the SAME as last year. (see image below)

What does this mean? There are many theories, and the prevailing wisdom is that long-term interest rates are driven by investors’ collective expectations for inflation and economic growth, while short-term rates are more directly manipulated by the Federal Reserve.

There are many possible ways to react to this information, but diversification has done a lot of useful work for investors as interest rates have changed over the years. We like diversifying bond portfolios across time frames (short-term, intermediate, long-term), across credit quality (AAA, AA, A, BBB, BB, B, etc), across issuers (federal, municipal, corporate, real estate) and across countries.

Doing this means that each component of the bond portfolio will perform well in different conditions. As conditions change over time, we expect that the investing experience will be less volatile compared to a non-diversified portfolio, while maintaining good prospects of achieving the level of return you need.

Case in point: international bonds have done relatively well compared to US bonds over the past couple of years. The opposite was true in the previous several years. Because they often behave differently, a portfolio combining both categories will likely be more stable.