This Isn't The Steeper Curve the Fed's Looking For

Falling stocks and a rising dollar won't be welcomed by monetary policymakers.

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For the past two years, all yield curve news has been bad news — for the Federal Reserve.

In a reversal of the defining trend of the past year, the spread between two and 10-year U.S. Treasuries — known as the yield curve — has widened to more than 90 basis points on Monday morning, its highest level since the Brexit vote, amid the worldwide tumult in bond markets.

While such a widening would normally be interpreted as a positive sign for the U.S. economy, the shape of the yield curve could nevertheless cause concern for a U.S. central bank seeking to balance the needs of the economy without upsetting global markets.

USGG10YR Index (US Generic Govt  2016-09-12 08-16-41
Source: Bloomberg

That's because the widening has been driven by a larger increase in 10-year yields than two-years, known as a steepening of the yield curve.

Such yield curves map out the rate paid to holders of government debt at various maturities, and generally slope upwards — a testament to the riskiness of lending money for a longer time period, as well as a partial reflection that central bank rates and inflation would generally be expected to rise.

So on the surface, this shift in the yield curve might be presumed to be a positive signal for the U.S. economy. The opposite dynamic — the prolonged period in which the curve flattened — was certainly taken to be a sign of economic malaise, or even malady.

For instance, the shrinking spread between short and longer-term Treasuries in the aftermath of the U.K. referendum signaled a 60 percent chance of a U.S. recession beginning in the next 12 months, according to analysts at Deutsche Bank AG.

Typically, the yield curve inverts prior to a recession — that is, the rate paid to holders of shorter-term debt exceeds that of longer maturities, a signal that market participants expect a downturn in activity that will elicit interest rate cuts from the central bank.

Alan Greenspan's Fed famously faced a "conundrum" on the yield curve: despite a series of rate hikes, longer-term yields failed to rise in tandem with those on shorter-dated debt. Janet Yellen's Fed has faced a similar issue: even after its recent rise, the 10-year Treasury yield is still well below where it was at the time of liftoff.

The steepening curve may, in theory, provide the Fed with more cover to hike without fear of triggering what's historically been a fairly accurate leading indicator of a recession.

But this isn't the type of steepener Fed officials are hoping for as it's coincided with the U.S. dollar rallying, and stocks sinking:

USGG10YR Index (US Generic Govt  2016-09-12 08-19-30
Source: Bloomberg

A loftier greenback hurts American exporters, while a decline in stock prices makes households feel less wealthy, thereby weighing on consumer spending.

In the aftermath of the housing bust, Fed researchers have placed more emphasis on these links between shifts in financial markets and real activity.

In fact, in the wake of the market turmoil that followed the devaluation of the yuan in 2015, Yellen indicated that the domestic U.S. economy was ready for a rate hike. However, the tightening of financial conditions — as well as the dimming growth prospects globally — stayed the Fed's hand until December, by which time stock prices had recovered considerably.

The simple answer here is that the sovereign debt drubbing has not been linked to expectations of higher short rates or a pick-up of inflation.

"The recent selloff in rates has not been in response to higher odds of a Fed hike (as the futures- or OIS-implied probabilities have not moved to anything near the same degree). Similarly, commodity prices have declined during the selloff," said George Pearkes, macro strategist at Bespoke Investment Group. "That leaves risk premium, which per the New York Fed's estimate is still deeply negative; a function of amongst other things international markets, domestic risk appetite, and declining inflation volatility over the longer term."

Positioning aside, at the heart of the bond selloff is the notion that central banks, particularly the Bank of Japan, might be on the verge of limits in their ability or willingness to continue their programs of quantitative easing. Massive asset purchases in the wake of the financial crisis put downwards pressure on the term premium; now, the potential for life without QE is doing the opposite to bonds around the world.

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