The world has dealt with a low base for interest rates since the 2008 financial crisis. The US Federal Funds Target Rate, the benchmark for overnight lending between banks, was between 0 and 25 basis points for more than five years after the most recent recession (Chart 1). In the current hiking cycle (as of June 30, 2018), the Fed has increased its target rate seven times. Despite this, interest rates are still well below historical averages experienced during previous Fed hiking cycles. This prompts questions about whether economic indicators that derive from interest rates, like a flattening yield curve,1 are still accurate in helping predict future recessions.

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The flattening curve explained
The yield curve is a visual representation of the yield of a bond at varying maturities. Chart 2 shows the US Treasury yield curve during four different time periods from 2013 to 2018. While yields on the short and long end ultimately determine the shape of the curve, they are affected by different factors. The Fed Funds Target Rate determines the short end of the yield curve. The long end is affected by the term premium, long-term growth expectations, and inflation expectations.

The yield curve first began to flatten in anticipation of the Fed's less accommodative monetary policy – the wind-down of quantitative easing2 undertaken during the Financial Crisis. This flattening continued in response to Fed Target Rate increases, which began in 2015. Fed hikes in the Target Rate since 2015 have increased the yield on the short end from near zero to 2.0%. However, as the expectations affecting the long end of the curve have remained virtually unchanged, the trend over the past five years has been a curve flattening due to short-term rates.

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A canary in the yield curve?
If the Fed Funds Rate continues to increase and long-term inflation expectations remain well anchored, the short end of the yield curve will likely continue to rise, resulting in a flatter curve. If this trend persists, the yield curve may become inverted, with short-term yields higher than long-term yields.

An inverted yield curve has historically signaled that the market expects a future economic slowdown combined with a monetary policy response from the Fed. Investors generally seek to lock in longer-dated yields in advance of an eventual Fed easing (lowering rates) by buying long-dated maturities. For these reasons, monitoring the shape of the yield curve can provide a good indicator of an impending (although not immediate) recession. In fact, the last seven US recessions were all preceded by an inverted yield curve.

Watching 2s and 10s
A measure that conveys the degree of steepness or flatness of the yield curve is the difference between the 2-year US Treasury Yield and 10-year US Treasury yield, commonly known as the 2s/10s spread (Chart 3). If the spread turns negative, it means that the yield curve has inverted. Analysis shows that despite the lower rate base since the last recession, the 2s/10s spread is still a valuable leading indicator.

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The Yield Curve Team at Loomis Sayles believes that the Fed is currently in the later stages of the hiking cycle. There have been seven rate hikes thus far, and the team believes there will be four more before the cycle ends. For historical perspective, the Fed reached a similar point in its previous hiking cycle in late 2005, when the 2s/10s spread ranged between 0.1% and 0.2%. Today, the 2s/10s spread sits at approximately 0.3%. The Fed has been much slower to raise rates coming out of the 2008 Great Recession, but the yield curve is still following a similar pattern as market participants anticipate an eventual economic slowdown. This substantiates the Loomis Sayles view that the economy is in the late expansion phase of the credit cycle.

Loomis Sayles Core Plus Bond Fund: Defensively positioned
The late expansion phase of the credit cycle is associated with slowing top line revenue growth, margin pressure and rising leverage. In response to this type of environment, the Loomis Sayles Core Plus Bond Fund has displayed more properties of the benchmark, meaning the fund has become more defensive, moved up in credit quality, and built more liquidity into the portfolio.

Many fund managers have increased allocations to "ballast" sectors like US Treasury, TIPS and Agency MBS, with the goal of providing protection in a risk-off environment. Investment grade credit and high yield credit have been reduced and sold into strength, with the remaining allocation focused on higher-quality, shorter-maturity names. In an effort to mute some of the interest rate sensitivity from the "ballast" sectors the team has increased exposure to bank loans, which are variable rate instruments that aim to provide protection from rising interest rates. While the transition to the next phase of the credit cycle (downturn) is not imminent, the signal from the 2s/10s spread is noteworthy. Its progression towards inversion is one indicator that suggests recession may be on the horizon.
1 The term flattening yield curve refers to a scenario in which short and long-term bond yields are closer together.

2 Quantitative easing (QE) refers to the introduction of new money into the money supply by a central bank.

Duration refers to a bond's price sensitivity to interest rate changes.

Yield Curve is a curve that shows the relationship among bond yields across the maturity spectrum.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity. Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields. Below investment grade securities may be subject to greater risks (including the risk of default) than other fixed income securities. Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets. Currency exchange rates between the US dollar and foreign currencies may cause the value of the Fund's investments to decline. Inflation protected securities move with the rate of inflation and carry the risk that in deflationary conditions (when inflation is negative) the value of the bond may decrease.

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This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

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