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How Bond Buyers Can Deal With an Inverted Yield Curve

Lou Carlozo

Current events have a way of gifting us with expressions that go from textbook terminology to textbook cliches in no time flat. And this month, Wall Street pundits turned a real head-scratcher into a nail-biter that they just can't stop saying: "inverted yield curve."

While that may sound like the name of a road construction technique, some market watchers have dubbed it the road to a recession. For in practical terms, an inverted yield curve refers to that rare occasion when short-term U.S. Treasury bonds actually earn more interest than long-term ones. The last time it happened? Right before the Great Recession. The curve also inverted before the recessions of 2000, 1991 and 1981.

U.S. Treasury yield curve rates began the week mired in that financial oddity. The yield on the two-year Treasury was 2.72 percent: the same as for the three-year and higher than the five-year at 2.7 percent. Only when you jump to the seven-year mark (2.77 percent) does the rate go higher.

[See: 10 of the Best Stocks to Buy for 2019.]

What does this mean for bond investors? While Treasurys are universally regarded as one of the safest investments around, watching their interest rates hop and flatten in confounding, confusing ways isn't quite the recipe for comfort.

"One scenario for 2019 is that long rates actually rise notably as the Fed continues to shrink its balance sheet, creating additional supply in the market on the long end," says Ellen Hazen, senior vice president and portfolio manager, F.L.Putnam Investment Management Co. in Wellesley, Massachusetts.

In this scenario, Hazen says, "the curve rises in parallel or perhaps steepens, and most 'risk-on' assets should perform well, such as U.S. corporate and high-yield bonds."

But there is also the chance the Fed will back off a bit, as each interest rate hike of recent has triggered grumbling from the White House to Wall Street.

"At this point, it's hard to see the Fed raising rates more than twice in 2019, given that inflation is still around 2 percent and growth is projected to moderate," says Michael DePalma, CEO at PhaseCapital in New York.

Assuming two 25 basis point hikes (a basis point equals 0.01 of 1 percent), that action "should not derail domestic bonds as long as central banks elsewhere stay put or move slowly," DePalma says. "Having said this, the market is currently pricing in about 45 percent chance of just a single hike in 2019."

Let's think about that for a moment. The market's so-called "45 percent chance" could be just as easily applied to a dice table in Vegas or a horse race at Churchill Downs. For the market, even in its dedication to financial exactitude, still loves a good gamble.

And so, DePalma wisely trots out any number of factors that could, if you will, roll snake eyes for bond markets: "Systemic risk keeps rising; troubles in Italy; Brexit is a train wreck; trade wars intensify; Fed turns more dovish but risk assets sell off; U.S. curve bull flattens; volume goes up and down but eventually declines."

[See: 9 Stocks That Dominate Your 401(k).]

What's a bond purchaser to do? "Safe haven sovereign long-maturity markets are the best performing overall," he says.

Then there is the question of corporate bonds -- and once again the "inverted" issue pops up, though in a different context.

"An inverse relationship exists between bond prices and interest rates," says Tony Bedikian, managing director, head of global markets at Citizens Bank. "If the Fed raises rates throughout 2019, the generally accepted scenario is that corporate bond prices would adversely be affected."

Once again, history proves instructive. In the late 1970s and early '80s, "the Fed ramped up overnight rates from 11.5 percent in September 1979 to 20 percent in March 1980," Bedikian says. That skyrocketing figure -- far more than all the interest rate hikes in the past 10 years combined -- didn't exactly work magic for bonds.

"The rapidly rising rate environment caused U.S. corporate bonds to plummet," he says. "However, if the Fed decides to pivot away from its tightening path, it could be a signal that will drive greater demand for corporate bonds."

But whether we are headed for a bear market and bad-news bonds, investors have at least enjoyed what you could call a "three bears" economy of fairy tale proportions for much of the year.

"Through 2017 and the first month of 2018, it was generally believed that we were in a Goldilocks investment environment," says Cliff Noreen, deputy chief investment officer at MassMutual in Springfield, Massachusetts. That means, in essence, a combination of just-right conditions.

These include "slow but growing economic growth (reflected in GDP), low inflation, very low interest rates, very strong and growing corporate profits, a significant drop in the corporate tax rate from 35 percent to 21 percent, and lower business regulations," he says.

[Read: Which Treasury Bonds Are the Best?]

But it seems, Goldilocks can no longer have her porridge and eat it too. "Now we have somewhat higher wage inflation and question marks on economic growth, along with trade negotiation concerns," Noreen says.

With so many moving parts, it may then behoove bond buyers to wait until the new year for some definitive answers. A word to the wise: Do not expect all the pieces fall into place. But if at the very least the threats of a trade war, interest rate mayhem or inverted curve madness pass, investors may just get a little peace.

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