Why flat yield curve is nothing to fear

Why flat yield curve is nothing to fear

Why flat yield curve is nothing to fear

Investors have been told not to fear a flat yield curve despite Canada being in a rate-rising environment.

The Bank of Canada, as widely predicted, kept its benchmark interest rate at 1.5% last week, citing the transitory nature of inflation – it reached 3% in July – sturdy economic data and the stabilizing of the housing market.

Rob Edel, chief investment officer at Nicola Wealth Management, said that rising rates coupled with a strong economy is not necessarily a bad thing – unless you have a lot of debt. He added that the short-term rates versus 10-year credit spread gives people more room than the two versus 10 and that this is more useful for investors.

He added that it’s only when the curve is inverted – and rates become more restrictive - that alarm bells should ring.

He said: “You have to keep your eye on the curve but a flat curve is not the issue; it’s when it actually inverts. 

“But the real question is why aren’t 10-year yields moving up? No one really has a great answer to that – part of it is because people think you aren’t going to have inflation and part of it is because, globally, rates are low and you have a lot of money flowing in to Canadian and US 10-year bonds, keeping the yields low.

“But if you honestly think the economy is getting stronger, you would think that the 10-year would start to move up and the fact it’s not is telling you something.”

Edel said he and colleagues at Nicola expect rates to increase but not by a great deal because there’s not much room to manoeuvre before the curve is inverted.

Once that scenario is upon us, however, the business cycle clock really starts to tick down to a possible recession. Edel believes that because so much of the market is built on algorithms, it may react to an inversion quicker than it would historically.

“That is something investors need to be wary of and be ready to start positioning their portfolios for,” Edel said.

“But what’s hard right now is that you look at stocks, how well they’ve done and you’re looking at the yield curve flattening and you are thinking ok, I should be reducing risk in my portfolio.  Everyone knows stocks are expensive but you can still get very good returns in this environment because monetary conditions are still very easy and the economy is still continuing to do well so that bodes well for risk assets.

“It’s when it turns that you’ve got to be very prudent and active in taking that risk away. If you want to start taking risk off now you lose some upside but I actually think it’s a smart move to start reducing that risk.”

 


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