Investing Advice: Steeper Curves Could Yield Black Swan

Posted On May 9, 2018 12:34 pm

One of the most important pieces of investing advice to follow is to listen and consider theses that might run counter to your own viewpoint.  In recent weeks here, I’ve been discussing the possibility that a flattening yield curve could portend a slowing economy, maybe even a recession. This would obviously bring about a bear market in stocks.

Well, a recent article from the Heisenberg report puts forth that the real risk would be a steepening of the yield curve.  I hadn’t given that much thought, but this prompted me to consider the fact that governments, especially the U.S. and Japan, are running huge deficits which need to be financed with debt. This will bring a large supply of Treasuries to auction in coming months.

That begs the question: with the Fed raising rates, will investors still be willing to gobble up bonds, especially longer dated at a measly sub 3% yield?  Will we ultimately start to see some auctions fail, and be unable to absorb the supply? This, in turn, could lead to an accelerated steepening of the curve.

Here is Heisenberg’s article explaining how steepening could lead to a black swan event.

There’s been a ton of chatter lately about relentless flattening in the curve and what it might or might not portend for the U.S. economy.

Although the 2s10s steepened for three straight sessions to close the week, that was off a decade low of just ~41 bps on Wednesday.

This has become a veritable obsession for pundits, even as analysts have variously attempted to take a more nuanced approach by trying to discern whether a flat or inverted curve necessarily means what it used to or otherwise has the same predictive power it may have had in past cycles.

Here’s what one analyst I spoke to over the weekend had to say:

I think in general this whole discussion about curve inversion as a predictor of recession is incorrect. I mean, there was some connection in the past, but causation has changed. The connection no longer holds. Even in 2007, the curve inverted for different reasons; it didn’t know about the recession, otherwise we would have avoided it.

 Related: Learn Why Sector Rotation is Good for Your Portfolio

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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