Aug 17, 2023 Multi Asset

Long View Q2: Inverted yield curves

Fixed income returns in inverted yield curve environments

Jason Chen

Jason Chen

Senior Portfolio Strategist
Dirk Schlüter

Dirk Schlüter

Co-Head, DWS House of Data
  • Return forecasts for the next decade are relatively unchanged from the start of the year, with a modestly higher fixed income return outlook and modestly lower returns for equities and other risk assets.
  • The inverted yield curve has been an important characteristic of the recent interest rate environment as a result of historically aggressive short-term interest rate hikes from global central banks.
  • Despite higher short-term interest rates, empirical evidence suggests intermediate-to-long-term duration instruments have typically realized higher returns over 3, 5, and 10 year periods.
  • Inverted yield curve regimes as a consequence of aggressive interest hikes are often short-lived and reinvestment risk can come back into play for strategic investors as short-term yields normalize.
  • Particularly as we near the end of interest rate increases in the US, investors should reasonably expect to realize positive term premium over medium-to-long-term periods based on empirical results



In this report, we present the DWS long-term capital market assumptions for major asset classes as of the end of June 2023 while exploring the risks to these forecasts.

As the global economy demonstrated resilience in the second quarter, risk assets continued their strong year-to-date performance, with global equities returning 6.2% in Q2, bringing returns to nearly 14% thus far this year. As economic growth forecasts continued to be revised higher amid a strong labor market and resilient consumer demand, interest rates also demonstrated a bias higher.

While the Federal Reserve (“the Fed”) only raised interest rates once in Q2, short-term interest rates moved measurably higher, with the 2-year US Treasury yield rising from 4.03% at the end of March to 4.90% to end June. The significant increase in the 2-year US Treasury yield reflects the significant shift in market pricing around short-term interest rates, where the first sign of interest rate cuts are not expected to occur until 2024 and the Fed Funds rate is now priced to exceed 5% through June of next year. As longer-term interest rates are typically less sensitive to short-term economic data, the increase in short-term interest rates has resulted in a significantly inverted US Treasury yield curve, which has driven strong investment demand for short-duration fixed income instruments.

While current yields look attractive for short-duration fixed income markets for the next few quarters, reinvestment risk is top of mind for fixed income investors as the peak in short-term interest rates nears. Inverted yield curve environments rarely persist, and term premia are generally realized over medium-to-longer-term investment horizons. Despite some hawkish bias, is remains prudent for investors to manage their portfolio durations, particularly those who have longer-term liabilities.

Our 10-year forecasts reflect these empirical observations, where differentials between the return outlook for sovereigns and equities is less dramatic relative to previous years, and the nominal return outlook for a multi-asset strategic allocation reflects this more benign strategic return landscape.

Our models now forecast an annual local currency  return of 6.6% for the MSCI All Country World Index (“ACWI”) over the next decade, versus 6.7% three months prior. At an aggregate level, we estimate the forecasted rate of return on a diversified portfolio at 6.2%, marginally lower from the level at the end of Q1.

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