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Apr 1, 2019

Bulletin | Why the world’s biggest bond investor is dismissing the recession warning of the yield curve

Sunny Oh

The head of the world’s largest bond fund says investors shouldn’t read too much into the recessionary signal coming from the U.S. Treasury market.
In an interview with MarketWatch, Daniel Ivascyn, group chief investment officer of Pacific Investment Management Company, or Pimco, said too many market participants were watching for an economic downturn by monitoring the twists and turns of the yield curve, which saw the rate on 10-year Treasurys fall below the 3-month Treasury bill yield on March 22, marking the first such inversion since 2007.
An inversion of the 10-year/3-month measure of the curve has been highlighted by researchers at the San Francisco Fed as a highly reliable recession warning signal, typically preceding a downturn by more than a year.
However, Ivascyn says investors have become overly anxious about recessionary signals despite evidence that the domestic economy remains solid. He said decelerating U.S. growth and lower terminal interest rates did point to falling yields, but he felt the recent rally was overstretched.
Besides growth concerns, the investment manager instead sees other factors that have contributed to the phenomenon of long-term yields falling below their short-term counterparts. He said a combination of technical factors including increased demand for longer-dated Treasurys because of a sharp uptick in mortgage refinancing applications may have amplified a recent bond-market rally, helping an inversion form even as the tight labor market and global growth outlook has yet to point to an imminent end to the U.S.’s second-longest expansion since World War II.
Read: The yield curve inverted — here are 5 things investors need to know
The catalyst for the yield-curve inversion were lost on market participants, with the S&P 500 index SPX, +0.89%  falling nearly 2%, while the Dow Jones Industrial Average DJIA, +1.00%  gave up 1.8% on March 22.
Equity markets have since staged a modest rebound, but the angst over the implications of the inversion to markets and the economy has spurred a litany of articles and analysis from market pundits.
See: Yield curve ‘overrated as an indicator,’ says Nobel-winning economist Robert Shiller
Is a recession in the cards?
Ivascyn says by Pimco’s own estimation, the risk of a domestic economic contraction this year is limited, even if recent data hint at some weakness taking hold. A final reading of gross domestic product on Friday indicated that the U.S. economy grew at annual pace of 2.2% in the final three months of 2018, a slower than earlier estimate of 2.6%
Still, the Pimco executive says Treasury investors’ increased pessimism over the U.S. economic outlook comes despite ultralow unemployment rates and a global economy that he believes will be steady in 2019, even if some cracks have appeared lately. Pimco is anticipating full-year GDP between 2% to 2.5%, which is roughly in line with economists’ consensus estimates polled by MarketWatch estimates for 2.3%.
“Given where our unemployment rate is currently, [a recession], holding all else equal, shouldn’t be much of a concern,” he said.
“When we look at the yield curve shape relative to our economic outlook, [the yield decline] is a bit overdone at least on the short-term,” said Ivascyn. Responsible for the firm’s Income Fund PIMIX, +0.00% which manages more than $115 billion in assets, Ivascyn took over as chief investment officer for Pimco after the acrimonious departure in 2014 of investing luminary Bill Gross.
The severity of the fall in yields for long-dated government debt has drawn as much investor attention as the inversion.
The 10-year Treasury note yield TMUBMUSD10Y, +3.13% slumped nearly 27 basis points in March to trade at 2.42%, marking its biggest monthly decline since Dec. 2018, according to Dow Jones Market Data.
The decline in yields, reflecting higher debt prices, can indicate bond investors anticipate lackluster growth, in turn, and subdued concerns about inflationary pressures that would erode fixed-income gains.
See: Bond market’s March madness leaves Treasury yields on track for biggest monthly drop since 2016
Read: This time, an inverted yield curve suggests the stock market has already peaked, some analysts say
He added the recent Treasury yield decline appeared to be driven more by bond buyers ramping up their debt purchases for technical reasons rather than those rooted in genuine recession concerns.
Ivascyn credited refinancing of home loans as at least part of the factor that has underpinned March’s bond-market rally.
He explained that as rate-hike expectations have faded, U.S. households have moved quickly to take advantage of the decline in fixed-income mortgage rates, which are pegged to benchmark Treasury yields. At current borrowing rates for a 30-year fixed mortgage, around 30% of such home loans are eligible for refinancing, based on Pimco’s calculations. The current 30-year rate fell to 4.07% last week.
Treasury purchases from real investment trusts, banks and other holders of mortgage-backed securities, reeling from the increased prepayments from homeowners rolling over their loans at lower rates, are some of the players involved in these mortgage related trades.
“This is the first time in a while we’ve seen a big pick-up in these technical flows,” said Ivascyn. The Pimco investor knows a thing about mortgage debt, having burnished his reputation as an astute investor during the 2008-09 financial crisis by buying up beaten-down mortgage bonds as the housing market imploded.
Also check out: Mortgage rates plunge at the fastest pace in a decade as growth fears resurface
More recently, an uptick in refinancing activity has meant that some of the underlying loans in mortgage-backed securities are being paid off early, shortening the average maturity of their fixed payments and reducing the interest earned from the mortgages. To hedge against the risk of diminished incomes from home loans, holders of mortgage-backed securities buy Treasurys with extended maturities, pushing their yields lower in a feedback loop of bond buying.
Applications to refinance home mortgages jumped 12% in the week ending March 27, according to the Mortgage Bankers Association.
Before last week, these so-called negative convexity inflows were considered a thing of the past, a powerful force when the Fed had yet to engage in quantitative easing and had, at one point, owned a third of agency mortgages — meaning those residential mortgage bonds tied to government-linked agencies Fannie Mae and Freddie Mac — bonds outstanding.
Unlike private investors, the central bank doesn’t look to make money from its MBS holdings and so doesn’t hedge its $4 trillion balance sheet against the vagaries of interest rates.
With the housing market staging a come back from last year’s doldrums, Ivascyn said he was sanguine on mortgage bonds and less interested in corporate debt, an increasingly popular trade among yield-hungry investors who anticipate low interest rates across the world will keep borrowing costs low and mute defaults. New-home sales rose nearly 5% in February to an annual pace of 667,000, an 11-month high.
Based in Newport Beach, Pimco managed around $1.7 trillion at the end of 2018.

Source: MarketWatch

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