Now Is Not The Time to Worry About the Yield Curve
The flattening yield curve -- that is, the narrowing in yields between longer-maturity government bonds and short-dated ones -- has attracted growing attention in recent weeks, and for good reason.
Historically, such flattening tended to signal future economic weakness. Its potential evolution into an inverted curve -- that is, longer-dated yields below those on shorter maturities -- has proven to be a reliable indicator of future recession.
It should come as no surprise that the front end of the yield curve has risen considerably this year. After all, the Federal Reserve has hiked interest rates three times and has signaled a similar number of increases for 2018.
More surprising is what has happened further out the curve -- or, rather, what has not happened. Longer-term yields have been relatively range-bound all year, with both 10-year and 30-year U.S. Treasuries trading at levels not far from where they were at the beginning of the year.
The resulting sharp flattening of the curve has understandably fueled concerns about a potential slowdown in U.S. growth and, with that, a higher risk of a policy mistake by the Federal Reserve. After all, that is what most historical models would indicate. Yet, and notwithstanding the peril of suggesting “This time is different," it may be premature to sound the alarm. Specifically, there are eight reasons why the information content of the curve’s shape may be less than implied by history.
- It’s not easy to find other market indicators that support the traditional signaling of a flattening curve. This is true not just for stocks and commodities, but also for other segments of the fixed-income market.
- Domestic economic indicators -- including higher-frequency, forward-looking ones -- suggest the growth momentum continues to build and that both wages and inflation may not remain so stubbornly muted.
- Most agree that the tax bill passed Wednesday by Congress is positive for short-term growth in the U.S. or, at a minimum, does not detract from it.
- Given the latest indications from the administration, Congress could be considering an infrastructure bill in the next few months that, if well-designed, could help enhance both potential and actual growth.
- The Fed remains highly data-dependent and would likely quickly revise its forward policy guidance to make it more dovish should fresh economic information unexpectedly show a weakening.
- The synchronized pick-up in growth in the rest of the world is supportive of the U.S. expansion.
- Continued large-scale purchases of securities by central banks (QE), particularly the Bank of Japan and the European Central Bank, have an indirect dampening effect on U.S. bond yields.
- Liability driven investment (LDI) flows -- purchases of longer-maturity bonds by institutions looking to “immunize” their liabilities -- have been turbocharged by the ability to monetize large profits on stock holdings and redeploy the proceedings in fixed income.
All of this suggests that the information content of today’s yield curve may not be as powerful as it has been in the past. Moreover, looking ahead, there are four factors that will likely moderate the technical influences that have fueled this year’s flattening:
- A reduction in central banks’ QE purchases, with the ECB already having committed to halving its monthly buys.
- An increase in the supply to the market of government bonds, for reasons that include loosening of fiscal conditions in the U.S.
- The currency-hedged yield available to foreign buyers has eroded and, in some cases, is now negative.
- A reduced pace of LDI activity.
Given the likely evolution of economic, policy and technical considerations, we should expect a steepening of the yield curve in the months ahead. Indeed, the last three trading sessions have resulted in a halt in the flattening and some modest steepening. Only if this change fails to take stronger hold in the next few months would there be reason to be concerned that the government bond market is indeed signaling a worrisome economic slowdown.
To contact the editor responsible for this story:
Max Berley at firstname.lastname@example.org