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Transcript - Winter 2019: Why is everyone always talking about the yield curve

Marija: [00:00:04] I'm Marija Majdoub, V.P. of investment management and strategy and senior portfolio manager here at MD Financial. I head the in-house investment team and we manage a number of global macro solutions for our clients including [the] global tactical opportunities pool and the strategic pools and funds. I am joined here today by Ian Taylor who is one of our portfolio managers and assistant vice president at MD and Ian Co-manages the solutions that I mentioned earlier. Hello Ian.

Ian: [00:00:34] Hello Maria.

Marija: [00:00:35] So I'd like to talk to our clients a bit about the yield curve. Interest Rate and yield curve are top of mind. Lots of talk in the news. I would like to get across our view on the yield curve. Where we think it's headed and how are we using those views in managing our portfolios. But to begin with, can you tell us a bit more what the yield curve is?

Ian: [00:00:53] Sure. So when you hear the term yield curve, what really you're referring to is really the difference between bonds of different maturities. So let's take an example, let's say the government of Canada bond or yield curve - you can measure what the bond yield is for a two year government Canada bond yield and a 10 year government bond yield. Generally if the 10 year is above the 2 year, which for the most part it is on average, we could call that a positively sloped yield curve. And so why is that important? The yield curve is important because it contains a lot of information around expectations or market expectations for the direction of monetary policy. So what central bankers are likely to do, economic growth and inflation. And even more importantly it contains expectations at different time periods, so you can really extract a lot of information from what market participants are expecting and that's important with a lot of good information.

Marija: [00:01:48] We've been expecting yield curves in North America to flatten for quite some time now. Can you tell our clients a bit more why?

[00:01:55] Yeah. So first of all let's explain what a flattening of the yield curve means. I gave the example of a positively sloped yield curve but when the yield curve flattens it generally means that the two year yield is rising, in general, at a faster pace than the long end of the yield curve which may not even rise and as such the positive yield curve is just becoming less positive - the slope of that yield curve. And It can even invert where the short end of the yield curve exceeds the long end of the yield curve. So, and our research is clear around this, this happens when central bankers are raising interest rates. And so when we have a strong conviction that they will continue to raise interest rates then, what we do is, we position the portfolios to underweight that short end of the curve where yields are going up, therefore bond prices are going down to a greater extent than what's happening at the long end of the yield curve, where monetary policy has less of an influence. And that's exactly how we've been positioned.

Marija: [00:02:48] So we changed that position recently, in early 2019. Could you explain why?

Ian: [00:02:54] Yeah absolutely. And I would say there's two fundamental reasons for that. The first reason for that is that it's become less clear what central bankers will be doing as we enter into 2019. As I said The U.S. Federal Reserve has been raising rates since 2015. They're certainly getting closer to what we would call more neutral levels, where they're not accommodating the economy, but they're not restricting the economy or at least what's generally expected to be more of those neutral levels. And that means that there's less room for them to raise interest rates. In addition to the market volatility we saw to the end 2018 which it created even less certainty around the path that those interest rates. So that's the number one reason last conviction and what the central bankers are going to do. I think the other side of that coin is that the yield curve has flattened materially. And so what that does is it leaves less opportunity to profit from that flattening of the yield curve. So we've adopted a more neutral stance here entering into 2019 just taking those two factors into account.

Marija: [00:03:49] There has been a lot of talk about the yield curve inverting, particularly up to the last quarter of 2018 - maybe not so much now but the risk still remains. What does that mean for the economy and for our portfolios?

Ian: [00:04:03] Yes, while the common understanding is that you know as the yield curve flattens and then inverts that it's a clear sign that a recession is coming. And, you know, historically that has been the case over the last 60 years - the yield curve has inverted prior to every single recession in the U.S. And so that's why it gets a lot of attention in the news. The challenge with that is that it's not always consistent with respect to the length of time prior to the recession that the yield curve inverts. So what we'd like to do is look at more than just the yield curve. We look at indicators of economic growth, inflation and corporate profitability and Really the capacity of the economy. And when we take that altogether, generally our view on this right now is that there is a low probability recession. Yes there are risks associated with interest rates being higher today than they were a few years ago. But as a whole the economy remains in pretty good footing which means you know, our expectation is that there's a low probability recession over the next 12 months. And generally that's supportive for the position of the rest of our portfolio. So really in conclusion we're looking at not just the yield curve but we're looking at a number of indicators and at this point it would indicate that there's a low probability of recession. Yes there are risks there but again we've taken a comprehensive look at that and that's really our view at this point.

Marija: [00:05:18] Great. Thank you Ian for walking us through our views on the yield curve direction and how we're using those views in managing our client portfolios here at MD