An excerpt from

FALL 2014

HOW TO PLAY THE

FLATTENING OF THE
(US) YIELD CURVE
Cathy Powers, CFA, Global Head of Rates and Sector Strategy
Ric Thomas, CFA, Global Head of Strategy and Research, Investment Solutions Group

Despite the markets’ recent skepticism about the timing of rate hikes, says
our fixed-income team, the US Federal Reserve’s next tightening cycle remains
on schedule. Here’s your strategy for staying ahead of the curve.

One of the key stories in 2014 has been the

flattening of the yield curve in the United Figure 1: Year-to-Date Yield Curve Twist
States. As we began the year, investors
Treasury Yield (%)
expected rising yields amid the tapering of
4
asset purchases and improving economic
growth. However, due to a number of factors,
Bullish Flattening
longer-dated Treasury yields actually fell
3
on higher demand, while the short end
of the curve rose modestly. How then should
investors position themselves going forward?
2
We think the year-to-date flattening is only
the beginning. In our view, investors should
brace for more flattening and position 1
themselves to take advantage of it. In this
piece, we outline why the curve will flatten
more and suggest trading strategies that
0 1 2 5 10 30
could help investors take advantage. month year year year year

— Yield Curve, January 2, 2014 — Yield Curve, October 7, 2014

A Curve and a Twist Source: US Department of the Treasury as of October 7, 2014.

After six years of suppressing interest rates Past performance is not a guarantee of future results.
through near-zero target federal funds
(FF) rates and large-scale purchases of
government and mortgage-backed securities,
the US Federal Reserve (the Fed) finally
indicated last December that it was ready to
phase out the asset purchases and at least

1 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT

 FLATTENING YIELD CURVE

talk about a rate hike. Typically, as we

approach Fed tightening, rates would be Figure 2: Search for Yield in 10-Year
expected to rise across the board but more
10-Year Yield (%)
so at the short end, where the market, no
4.5
longer anchored by loose monetary policy,
would start repricing future increases in
the FF rate. At the long end, yields would
generally rise less, primarily on expectations 3.0
that tightening will mitigate inflation risk.
The yield differential (spread) between
2- and 5-year Treasuries would narrow
relative to 30-year bonds and the yield curve 1.5
would flatten, as they say. Fixed-income
investors would be inclined to shift their
exposure from shorter- to longer-term bonds
0.0 Jan Mar May Jul Oct
and put on “flattener” trades that benefit 2014 2014
from a convergence between short- and
— US — Germany — Spain — Italy — Japan
long-term rates.
Source: Bloomberg as of October 20, 2014.
Past performance is not a guarantee of future results.

In 2014, instead of a typical

Figure 3: Broad Labor Market Indicators Display Positive Momentum
bearish flattening from a larger
rise in short-term rates, what we Monthly Change in Labor Market Conditions (LMCI) (%) Unemployment Rate (U-3) (%)

saw was a bullish flattening. 20 12

10 10

0
8
But a strange thing happened in 2014. -10
The yield curve started to flatten ahead of 6
schedule, at a time when rates were still -20
falling rather than rising. Not only that, 4
-30
instead of a typical “bearish flattening” from
a larger rise in short-term rates (and a more -40 2

bearish outlook for short-term bonds), what

we saw was a “bullish flattening” driven
by declining long-term rates. Year-to-date,
30-year Treasuries have fallen by 76 bps,
while the 2- and 5-year Treasuries have risen
by 18 bp and 2 bp, respectively (Figure 1).
In retrospect, there are logical reasons why
this yield curve twist occurred. Reduced
expectations for actual and potential GDP in
the early part of the year prompted a strong
bid for the long end of the curve, and a spike
in geopolitical tensions created a safe-haven
bid for Treasuries. The strong US dollar
and the still-competitive edge enjoyed by
Treasuries over yields elsewhere—particularly
in Europe (Figure 2)—also played a role.
-50 Jan
1992 1997
— Fed Labor Market Conditions Index (LMCI)
Source: US Federal Reserve, Bureau of Labor Statistics as of September 30, 2014.
And we now think there may be secular
factors at work, as well, involving
fundamental shifts in the supply-demand
dynamics of the bond markets. (See “The
Not-So-Great Rotation and What It Means
for the Markets,” page 7.) Even so, the
bullish flattening this year did throw the
market a curve.
Sep 0
2003 2009 2014
— Unemployment Rate (U-3)
So What Now?
Against the backdrop of this year’s unusual
turn of the yield curve, the market seems
to be questioning the Fed’s projections
for future rate hikes. The future shape of
the yield curve will largely depend on the
Fed’s outlook for economic activity and its
assessment of progress toward employment

2 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT


and inflation goals. But where the Fed has
begun to acknowledge progress, the market
seems skeptical that higher rates will actually
follow. We believe the market is being too
complacent, for a couple of reasons.
First, there is no longer any question that the
Fed’s economic stimulus plans are working,
especially with regards to the labor market.
It’s true, as Fed Chair Janet Yellen continually
reminds us, that it will be difficult to raise
rates as long as slack still remains in the
job market—one big reason the Federal
Open Market Committee (FOMC) members
continue to say that they expect “a
considerable time” to elapse between the
end of asset purchases and the first rate hike.1
Nonetheless, it is becoming increasingly
difficult to dismiss the improvement in job
conditions (Figure 3). At 5.9 percent in
September, the US unemployment rate has
declined over 400 bps from its peak in
October 2009, and it is now within striking
distance of the FOMC’s longer-run target of
between 5.2 percent and 5.5 percent.2
A quick look at the Eurodollar
futures curve shows that the
market doesn’t seem to be
on the same page as the Fed.
The goalpost for inflation is slightly further
away. The Fed has set a target for personal
consumption expenditures (PCE) at 2
percent—the level it considers high enough
to be consistent with stable inflation. The
most recent PCE report came in at 1.5
percent year-over-year. Wage inflation,
meanwhile, has trended sideways, which
the Fed views as evidence of remaining
labor market slack (Figure 4).
However, wage inflation should pick up as
the labor market sustains its momentum
and slack is reduced, suggesting that it is
probably only a matter of time before inflation
starts to inch closer to the Fed’s target.
The FOMC is calling for both PCE and Core
PCE to rise to a range of 1.9 percent to 2
3 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT
Figure 4: Major Inflation Indicators Show Lack of Wage Pressure
Year Over Year (YoY) Changes (%)
5
4
3
2
1
0 Jan
1990 2009
— Core PCE YoY — Avg Hourly Earnings YoY
Source: Bloomberg as of September 30, 2014.
percent in 2017. We are not quite there yet,
in other words, but as the Fed’s employment
and inflation targets are increasingly close to
being met, we expect the Fed will take the
next step in rate normalization.
Importantly, it is also what the Fed’s own
projections suggest. The Fed “dot plot”
(Figure 5) charts the FOMC members’
expectations for the trajectory of the FF rate.
The dot plot is released every quarter when
the Fed provides its Summary of Economic
Projections, which updates the FOMC’s
forecasts for GDP, inflation, unemployment
and the FF rate. Based on the projections
from the September 17, 2014, dot plot,
FOMC members are projecting the median
FF rate will reach 1.375 percent , 2.875
percent and 3.75 percent by year-end 2015,
2016 and 2017, respectively. The FOMC also
provides a forecast for longer-run FF, which
represents the level of rates that it considers
to be consistent with its employment and
inflation goals. From March to June of this
year, the median estimate for longer-run FF
fell from 4 percent to 3.75 percent, but it
has held steady at that level since. And the
newly released 2017 median projections
have closed the gap between 2016 and the
longer run, suggesting a tightening cycle that
would span no more than about three years.
But the Fed and the market don’t seem to
be on the same page. A quick look at the
FLATTENING YIELD CURVE
Sep
2010 2012 2014
— Employment Cost Index YoY — Fed Target — PCE YoY
Eurodollar futures curve, a proxy of future
pricing for the money-market curve, bears
this out. In Figure 6, we see that the
Eurodollar futures’ projected rate path is
below that of the Fed’s, and the divergence
increases over time. The Eurodollar futures
curve is indicating that rate hikes in 2017
will be roughly a percentage point below the
Fed’s median forecast. Furthermore, based
on market pricing, it would take more than
five years to reach the equilibrium longer-run
3.75 percent FF rate. That is almost twice
as long as the Fed’s current projections
and many times longer than past tightening
cycles, which have averaged a mere 12
months. The latest rate hike cycle (June
2004 to June 2006), relatively lengthy by
historical standards, lasted just 24 months.
Why is the market dragging its feet? Perhaps
it has simply grown inured to the prospect of
higher short-term rates. On several occasions
over the last five years, investors have been
surprised by weak growth. Additionally, the
lack of inflationary pressures has lessened
the need to tighten the policy earlier, perhaps
contributing to skepticism that the Fed will
actually raise rates as much as it indicates it
will when the time comes. However, we think
history provides an important reality check
here. As seen in Figure 7, once the Fed
starts to tighten, the curve tends to flatten—
and flatten pretty demonstrably.
 FLATTENING YIELD CURVE

How to Play It Figure 5: Fed Rate Projections for 2017 Are In Line with
The key challenge in this environment will be Longer Run Projections
Fed communication. With the data-dependent FF Rate
Flow (bp (%)
of Market Value)
nature of policy decisions, the potential for 5
conflicting interpretations of new economic
data is high. Combined with the market’s
4
complacency about the rate hike cycle, it’s
a perfect recipe for volatility—and a good
3
argument for strategies designed to capitalize
on rising short-term rates. The yield curve
flattener known as a “barbell” and short 2

duration positions are two common

approaches used in such an environment. 1

Currently, we prefer the barbell, given that

the short duration is only profitable when 0 2015 2016 2017 Longer
Run
rates rise and we believe that we are still
Source: US Federal Reserve as of September 17, 2014.
about six to nine months away from the first
The median FF projections are 1.375% for 2015, 2.875% for 2016, and 3.75% for 2017.
hike. The barbell, in contrast, provides the
potential for positive payouts in a variety of
scenarios, including the less likely event that
rates go down.
Figure 6: Eurodollar Futures Show Market Expectations Lag Fed Forecasts
Here, we conduct a side-by-side comparison
of the two strategies. In our scenario, we Yield (%)

assume that the 5- and 30-year yield curve 4

slope will flatten to zero in three years’ time
(Figure 8), since the average slope at the end
of the last five rate hike cycles was -1 bps.
This is 43 bps lower than what the market’s
forward pricing is projecting, creating our
window of opportunity, as it were.
Using this perspective, we compare the
return profile of a short duration position
in the 10-year Treasury and barbell (Figure
9). In our preferred barbell positioning,
investors underweight 2- to 5-year Treasuries
and overweight 30-year Treasuries while
keeping the duration neutral. Profitability
of these strategies is based on an equal
duration of one year. Investors can do this,
for example, by selling 20 percent in 5-year
bonds (.20 x 4.9 = 1 year duration) and
buying 5 percent in 30-year bonds (0.05 x
19.8) also equivalent to one-year duration.
While both strategies appear generally
profitable, the uncertain timing of rate hikes
and the potential ways in which the yield
curve may shift currently favor the barbell
strategy in each of the two scenarios we
tested (Figure 9). Of course, the success of
both strategies, though, is heavily dependent
on the timing of rate hikes and the projected
levels relative to forward pricing.
3.75
3 2.875
2
1.375
1
0 Dec Sep Jun Mar Dec
2014 2016 2018 2020 2021
Source: Bloomberg, US Federal Reserve as of October 21, 2014.
Reallocating in 3-D MSCI World Equity Index (the Initial
Portfolio in Figure 10). The Barcap Agg
Still, fixed-income portfolios rarely exist in has a 5.5-year duration as of June 30.
isolation. So, when reducing interest-rate Given a 40 percent allocation, this
risk at a time like this, it begs the question translates into a portfolio dollar duration
of where else to spend one’s risk budget of 2.2 (40 percent x 5.5 = 2.2). As in our
to maximize risk-adjusted returns. barbell strategy, we can now think about
changing our allocations to give a bigger
Our solutions team recently looked at
weight to longer-duration bonds, provided we
this question as it relates to some of its
also trim the dollar amount of our allocations
multi-asset-class portfolios. Consider an
to keep the duration constant. For example,
investor allocating 40 percent of a portfolio
by shifting about half of the 40 percent
to the Barcap Aggregate Bond Index (Barcap
Barcap Agg allocation into fixed income
Agg) and 60 percent to the cap-weighted
investments with an 11-year duration,3

4 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT

 FLATTENING YIELD CURVE

low-volatility stocks. While such strategies

Figure 7: 5- and 30-year Treasury Curve Flattening Trend During generally underperform in risk-on
Rate Hike Cycles environments, these strategies tend to
more than compensate with a lower equity
5 Years–30 Years Yield Curve Slope
50
beta and higher dividend yield than
standard cap-weighted strategies.

-50

-100 There are simple methods

for maintaining beta
-150
neutrality while simultaneously
adding to equity or other
-200 -6 month 6 12 18 24
months 0 months months months months risk-asset allocations.
— 1994 — 1997 — 1999 — 2004 — Last 6 Months

Source: Bloomberg as of September 19, 2014.

Month 0 is 1 month before the first rate hike.
Past performance is not a guarantee of future results.
Figure 8: Expect Curve Flattening Beyond Forwards
5 Years–30 Years Yield Curve Slope (bp)
200
100
0
-100 1987 1989 1995
— Spread — 15-Day Average Volume of High-Yield Exchange-Traded Funds as Percentage of Market
Source: Bloomberg as of September 30, 2014.
we can maintain a dollar duration of 2.2
(20 percent x 11 = 2.2) by halving the fixed
income allocation. This frees up 20 percent
of capital for use in more growth-oriented
asset classes, such as equities, high-yield
bonds, infrastructure or private equity.
But, almost by definition, more growth means
more risk. A new increased allocation to
riskier assets would increase the total beta
of the portfolio, subjecting it to greater
propensity for drawdowns during periods
2000 2006 Average Current 3 Years
Forward
of financial distress. Fortunately, there are
simple methods for maintaining beta
neutrality while simultaneously adding to
equity or other risk-asset allocations.
In order to keep the effective equity beta
constant, in our example, equities are
converted from a cap-weighted equity
strategy into a minimum-volatility equity
strategy. During the past few years, indexers
and asset managers have designed many
versions of equity strategies that overweight
In Figure 10, we show the mechanics of
how all this works together. As can be seen,
we have increased our equity allocation from
60 percent to 80 percent, but the entire
portfolio is now moved to a low-volatility
portfolio, carrying a beta of 0.7. This keeps
the overall portfolio beta at 0.56, slightly
below the original portfolio beta of 0.6,
reducing the potential for drawdowns. At the
same time, we have achieved an additional
80 bp in overall portfolio equity yield versus
the initial portfolio, while maintaining the
same dollar duration.
US Treasury yields are some of the most
heavily scrutinized economic indicators
in the world, providing insight into inflation
expectations, interest rate outlooks and
growth trends. As we think about the future
path of the US yield curve, particularly once
rates begin to normalize, fortunately we have
historical trends to guide us. History, along
with economic forces, suggests to us that
more yield curve flattening is on the way.
Investors can look to take advantage through
flattener trades, such as barbells or multi-
asset-class trading strategies. The key to
profiting from our expected trajectory is
focusing on the strategies that are best
equipped to take advantage of the market
volatility that is likely to accompany the
next rate hike cycle.
1
The September 17, 2014, Fed press release includes the
following language: “The Committee continues to anticipate,
based on its assessment of these factors, that it likely will
be appropriate to maintain the current target range for the
federal funds rate for a considerable time after the asset-
purchase program ends, especially if projected inflation

5 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT

 FLATTENING YIELD CURVE

client assets but were achieved by means of the retroactive

Figure 9: Hypothetical Projected Profitability application of a model that was designed with the benefit of
hindsight. The simulated performance was compiled after the
end of the period depicted and does not represent the actual
Current Future investment decisions of the advisor. These results do not
10-Year Rate & FF Rate Forward Profit vs reflect the effect of material economic and market factors on
Strategy Duration (years) 5–30Y Spread Scenarios Pricing Forwards decision-making.
Short 10Y UST 1.00 2.17 3.50 2.85 0.65 The simulated performance data is reported on a gross of fees
basis, but net of administrative costs. Additional fees, such
Short 10Y UST 1.00 2.17 3.10 2.85 0.25 as the advisory fee, would reduce the return. For example, if
an annualized gross return of 10% was achieved over a 5-year
5–30Y Flattener 1.00 1.55 0.00 0.58 0.58 period and a management fee of 1% per year was charged
and deducted annually, then the resulting return would be
5–30Y Flattener 1.00 1.55 -0.15 0.58 0.73 reduced from 61% to 54%. The performance includes the
reinvestment of dividends and other corporate earnings and
Source: Bloomberg as of October 20, 2014. is calculated in US dollars.
The simulated performance shown is not necessarily indicative
of future performance, which could differ substantially.
Risk associated with equity investing include stock values
which may fluctuate in response to the activities of individual
Figure 10: Simulated Portfolio* companies and general market and economic conditions.
Barclays POINT/Global Family of Indices. [2014] Barclays Inc.
Used with permission.
Assett Class & Characteristics Initial Portfolio New Portfolio
Investing in futures is highly risky. Futures positions are
considered highly leveraged because the initial margins are
Global Min Volatility Equity — 80%
significantly smaller than the cash value of the contracts.
Global Cap-Weighted Equity 60% — The smaller the value of the margin in comparison to the
cash value of the futures contract, the higher the leverage.
Total Equity 60% 80% There are a number of risks associated with futures investing
including but not limited to counterparty credit risk, currency
Cap-Weighted Fixed Income 40% — risk, derivatives risk, foreign issuer exposure risk, sector
concentration risk, leveraging and liquidity risks.
Long Duration Fixed Income — 20%
Derivative investments may involve risks such as potential
Total Fixed Income 40% 20% illiquidity of the markets and additional risk of loss of principal.
Bonds generally present less short-term risk and volatility
Total Portfolio 100% 100%
than stocks, but contain interest rate risk (as interest rates
rise bond values and yields usually fall); issuer default risk;
Equity Beta 1.00 0.7 issuer credit risk; liquidity risk; and inflation risk. These effects
Total Asset Beta 0.6 0.56 are usually pronounced for longer-term securities. Any fixed
income security sold or redeemed prior to maturity may be
Equity Yield 2.4% 2.8% subject to a substantial gain or loss.
Total Portfolio Equity Yield 1.4% 2.2% Investing in foreign domiciled securities may involve risk of
capital loss from unfavorable fluctuation in currency values,
Fixed Duration 5.5 11 withholding taxes, from differences in generally accepted
Total Asset Duration 2.2 2.2 accounting principles or from economic or political instability
in other nations.
Investments in emerging or developing markets may be more
Source: Barclays, MSCI, State Street Global Advisors as of August 31, 2014.
volatile and less liquid than investing in developed markets and
Allocations are are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. may involve exposure to economic structures that are generally
The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. less diverse and mature and to political systems which have
Please see appendix for additional information. less stability than those of more developed countries.
*T
 his is a hypothetical asset allocation shown for illustrative purposes only. Characteristics shown are actual data, MSCI makes no express or implied warranties or
based on the hypothetical portfolio. representations and shall have no liability whatsoever with
respect to any MSCI data contained herein. The MSCI data
may not be further redistributed or used as a basis for other
indices or any securities or financial products. This report is
not approved, reviewed or produced by MSCI.
continues to run below the Committee’s 2 percent longer-run All material has been obtained from sources believed to be
goal, and provided that longer-term inflation expectations reliable. There is no representation or warranty as to the Investing in high yield fixed income securities, otherwise
remain well anchored.” accuracy of the information and State Street shall have no known as “junk bonds”, is considered speculative and involves
liability for decisions based on such information. greater risk of loss of principal and interest than investing in
2
In the September 2014 Summary of Economic Projections investment grade fixed income securities. These Lower-quality
from the Fed, FOMC participants estimated that unemployment The views expressed in this material are the views of SSgA Fixed debt securities involve greater risk of default or price changes
has a long-run central tendency of 5.2 percent to 5.5 percent. Income through the period ended October 31, 2014 and are due to potential changes in the credit quality of the issuer.
3
 longer duration is easily obtained by shifting assets
A subject to change based on market and other conditions. This
document contains certain statements that may be deemed Asset Allocation is a method of diversification which positions
from the Barcap Agg into a combination of long-duration, assets among major investment categories. Asset Allocation
high-quality corporate bonds; long-dated strips; swaps forward-looking statements. Please note that any such statements
are not guarantees of any future performance and actual results may be used in an effort to manage risk and enhance returns.
or futures contracts. It does not, however, guarantee a profit or protect against loss.
or developments may differ materially from those projected.
Important risk information: Investing involves risk including Currency Risk is a form of risk that arises from the change
the risk of loss of principal. The simulated performance shown was created by SSgA
Fixed Income. This is a hypothetical asset allocation shown in price of one currency against another. Whenever investors
The whole or any part of this work may not be reproduced, for illustrative purposes only. Characteristics shown are or companies have assets or business operations across
copied or transmitted or any of its contents disclosed to third actual data, based on the hypothetical portfolio. The results national borders, they face currency risk if their positions
parties without SSgA’s express written consent. shown do not represent the results of actual trading using are not hedged.

6 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT

 FLATTENING YIELD CURVE

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7 STATE STREET GLOBAL ADVISORS | IQ: FALL 2014 ISSUE EXCERPT