No apologies for returning to the US yield curve once again -- well, maybe just a small one -- but the subject is garnering ever more airtime and column inches in the financial media. A host of experts are keen to remind us that flattening yield curves have a pretty good record when it comes to signalling economic slowdowns, and inverted yield curves (short term yields actually higher than long term yields) have an even better one in predicting recessions. On the face of it and looking at the data, neither of those two developments seem obviously likely in the near future -- which is precisely why the wise investor should be keeping a close eye on the curve.
A flattening yield curve damages the profitability of the crucial banking sector by removing, or at least reducing, the net interest margin (NIM) that banks have traditionally harvested from borrowing short term (largely from their depositors) at lower rates, and lending longer term at higher rates. And if there's no incentive for banks to keep lending, the whole economy suffers too.
In addition, the current curve-flattening scenario of long-term yields refusing to budge even as the Fed tightens at the short end means that the central bank's ammunition, should they have to wade in with supportive policy in the future is limited. In short, the gradual process of rate normalisation that the Fed is undertaking with its programme of hiking short-term rates is undermined by the continuing depressed level of long-term yields.
So how much flattening have we seen so far ? Bloomberg have kindly mapped out the reduction in the differentials between maturities since the beginning of the year :
The 2yr / 10yr spread is at 74 basis points, down from 125bp
The 2yr / 30yr spread is at 122 basis points, down from 187bp
The 5yr / 10yr spread is 35 basis points, down from 52bp
The 5yr / 30yr spread is 83 basis points, down from 114bp
Now, during a period of Fed tightening such as the one we're in now you would expect some flattening as longer bond yields react more slowly to the Fed's hikes in overnight rates, and indeed may never fully reflect them. The 2yr Treasury is a lot more sensitive to such hikes than it's longer-term equivalents, which are more influenced by inflation and economic growth. The fact is that this year, rather than just rise more slowly, yields on Treasuries with maturities of 10 years and more have actually fallen -- and we can put that down to stubbornly low inflation numbers.
That's led some to suggest that the responsibility for the yield curve flattening lies with the Fed's determination to be ahead of the game when it comes to keeping a lid on inflation, and that they've tightened too quickly. The Fed really can't win on this one ..... there are plenty of others around who argue that the Fed have erred on the side of caution. As we've often said, all the conditions that would normally have stimulated inflationary pressures in the past are in place, and if and when they do percolate through as the Fed believes they will then longer bond yields will rise, the curve will steepen and the central bank will look pretty clever.
Whether the Fed has acted in timely fashion or not, there are other reasons why yields at the longer end are being suppressed. The most simple of them is just a matter of plain old supply and demand. Pension funds and insurance companies will always have a need for long-dated assets to match their long-dated liabilities, and they've been joined on the bid side in recent times by huge "passive" mutual funds like Vanguard and Blackrock. So there's no lack of demand, but on the supply side the Fed have announced that they will be looking to focus their issuance more to the short end, Bills and short-dated bonds (up to 5yrs ?) . As with every market, increased demand and reduced supply means higher prices ..... and in bond markets of course higher prices mean lower yields.
There are also global factors to consider. The Fed may be beginning to gently reduce their balance sheet, but the Bank of Japan remains in fully supportive mode and for all the tapering talk the ECB continues with its QE programme (albeit at a reduced pace). For those outside of the US struggling with ultra-low or even negative yields, a 10yr US Treasury with a yield of 2.35% (say) is a pretty attractive instrument. If we're talking about central bank caution, that could be the ECB's watchword and whilst they're still purchasing the long end of the curve, don't expect demand for longer Treasuries to dry up either.
It's possible that if the dynamics that drive inflation really have changed , we should expect lower long-term yields (and a flatter curve) to accompany lower inflation. If not, then we need to be aware that an indicator with some good form behind it is getting uncomfortably close to telling us that tough times are ahead. Or there's that other possibility ...... inflation's coming eventually which will lift long yields and naturally steepen the curve. Some respected judges have been forecasting such a development for a while, calling for an end to the 30yr bull market in bonds and the yield on 10yr Treasuries to jump to 3.00%.
That would sort out the curve flattening problem ...... and maintain the credibility of those experts whose repeated warnings have so far come to nothing.